subgradient matlab,Numerical Methods in Finance

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Numerical Methods in Finance

and Economics

A MATLAB-Based Introduction

Second Edition

Paolo Brandimarte

Politecnico di Torino

Torino, Italy

@XEliciENCE

Part I Background

Contents

1 Motivation

1.1 Need for numerical methods

1.2 Need for numerical computing environments:

why MATLAB?

1.3 Need for theory

For further reading

References

2 Financial Theory

2.1 Modeling uncertainty

2.2 Basic financial assets and related issues

2.2.1 Bonds

2.2.2 Stocks

xvii

xxiii

3

4

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13

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25

30

30

31

Vii

viii CONTENTS

2.2.3 Derivatives

2.2.4

Fixed-income securities: analysis and portfolio

immunization

2.3.1

2.3.2

2.3.3

2.3.4

2.3.5 Critique

2.4.1 Utility theory

2.4.2 Mean-variance portfolio Optimization

2.4.3 MATLAB functions to deal with meanvariance

portfolio optimization

2.4.4 Critical remarks

2.4.5 Alternative risk measures: Value at Risk

Modeling the dynamics of asset prices

2.5.1

2.5.2 Standard Wiener process

2.5.3 Stochastic integrals and stochastic

2.5.4 Ito’s lemma

2.5.5 Generalizations

2.6 Derivatives pricing

2.6.1

2.6.2 Black-Scholes model

2.6.3 Risk-neutral expectation and Feynman-

KaE formula

2.6.4 Black-Scholes model in MATLAB

2.6.5 A few remarks o n Black-Scholes formula

2.6.6 Pricing American options

Introduction to exotic and path-dependent options

2.7.1 Barrier options

2.7.2 Asian options

2.7.3 Lookback options

Asset pricing, portfolio optimization, and

risk management

2.3

Basic theory of interest rates: compounding

and present value

Basic pricing of fixed-income securities

Interest rate sensitivity and bond portfolio

immunization

MATLAB functions to deal with fixedincome

securities

2.4 Stock portfolio optimization

and quantile- based measures

From discrete t o continuous time

2.5

diflerential equations

Simple binomial model f o r option pricing

2.7

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123

CONTENTS ix

2.8 An outlook on interest-rate derivatives

2.8.1 Modeling interest-rate dynamics

2.8.2

For further reading

References

Incomplete markets and the market price

of risk

Part 11 Numerical Methods

3 Basics of Numerical Analysis

3.1 Nature of numerical computation

3.1.1 Number representation, rounding, and

3.1.2 Error propagation, conditioning, and

3.1.3

Solving systems of linear equations 145

3.2.1 Vector and matrix norms 146

3.2.2

3.2.3

3.2.4 Tridiagonal matrices

3.2.5

truncation

instability 141

Order of convergence and computational

complexity 143

3.2

Condition number for a matrix 149

Direct methods for solving systems of

linear equations

Iterative methods for solving systems of

linear equations

3.3.1 Ad hoc approximation

3.3.2 Elementary polynomial interpolation

3.3.3 Interpolation by cubic splines

3.3.4

3.3 Function approximation and interpolation

Theory of function approximation by least

squares

3.4 Solving non-linear equations

3.4.1 Bisection method

3.4.2 Newton’s method

3.4.3 Optimization- based solution of non-linear

equations

3.4.4 Putting two things together: solving

a functional equation by a collocation

method

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138

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198

204

x CONTENTS

3.4.5 Homotopy continuation methods 204

For further reading 206

References 207

4 Numerical Integration: Deterministic and Monte Carlo

Methods

4.1 Deterministic quadrature

4.1.1 Classical interpolatory formulas

4.1.2 Gaussian quadrature

4.1.3 Extensions and product rules

4.1.4 Numerical integration in MATLAB

4.2 Monte Carlo integration

4.3 Generating pseudorandom variates

4.3.1 Generating pseudorandom numbers

4.3.2 Inverse transform method

4.3.3 Acceptance-rejection method

4.3.4

Setting the number of replications

4.5.1 Antithetic sampling

4.5.2 Common random numbers

4.5.3 Control variates

4.5.4 Variance reduction by conditioning

4.5.5 Stratified sampling

4.5.6 Importance sampling

4.6 Quasi-Monte Carlo simulation

4.6.1 Generating Halton low-discrepancy

sequences

4.6.2 Generating Sobol low-discrepancy

sequences

For further reading

References

Generating normal variates by the polar

approach

4.4

4.5 Variance reduction techniques

5 Finite Diflerence Methods for Partial Digerential

Equations

5.1 Introduction and classification of PDEs

5.2 Numerical solution by finite diflerence methods

5.2.1 Bad example of a finite diflerence scheme 295

209

21 1

21 2

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CONTENTS xi

5.2.2

Explicit and implicit methods for the heat

equation

5.3.1

5.3.2

5.3.3

5.4 Solving the bidimensional heat equation

5.5 Convergence, consistency, and stability

For further reading

References

Instability in a finite diflerence scheme

5.3

Solving the heat equation by an explicit

method

Solving the heat equation by a fully

implicit method

Solving the heat equation by the Crank-

Nicolson method

297

303

304

309

31 3

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324

6 Convex Optimization 327

6.1 Classification of optimization problems 328

6.1.1 Finite- us. infinite-dimensional problems 328

6.1.2 Unconstrained us. constrained problems 333

6.1.3 Convex us. non-convex problems 333

6.1.4 Linear us. non-linear problems 335

6.1.5 Continuous us. discrete problems 337

6.1.6 Deterministic us. stochastic problems 337

6.2.1 Steepest descent method 339

6.2.2 The subgradient method 34 0

6.2.3 Newton and the trust region methods 34 1

method and simplex search 342

6.3 Methods for constrained optimization 34 6

6.3.1 Penalty function approach 34 6

6.3.3 Duality theory 357

6.2 Numerical methods for unconstrained optimization 338

6.2.4 No-derivatives algorithms: quasi-Newton

6.2.5 Unconstrained optimization in MATLAB 343

6.3.2 Kuhn-Tucker conditions 351

6.3.4 Kelley 's cutting plane algorithm 363

6.3.5 Active set method 365

6.4 Linear programming 366

6.4.1 Geometric and algebraic features of linear

programming 368

6.4.2 Simplex method 370

xi; CONTENTS

6.4.3 Duality in linear programming

6.4.4 Interior point methods

6.5.1 Linear programming in MATLAB

6.5.2 A trivial LP model for bond portfolio

management

6.5.3 Using quadratic programming to trace

evgicient portfolio frontier

6.5.4 Non-linear programming in MATLAB

6.5 Constrained optimization in MATLAB

6.6 Integrating simulation and optimization

S6.1 Elements of convex analysis

S6.1.1 Convexity in optimization

S6.1.2 Convex polyhedra and polytopes

For further reading

References

Part 111 Pricing Equity Options

7 Option Pricing by Binomial and Thnomial Lattices

7.1 Pricing by binomial lattices

7.1.1 Calibrating a binomial lattice

7.1.2

7.1.3

Pricing American options by binomial lattices

Putting two things together: pricing a

pay-later option

An improved implementation of binomial

lattices

7.2

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397

4 01

4 02

4 03

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414

7.3 Pricing bidimensional options by binomial lattices 41 7

7.4 Pricing by trinomial lattices 422

7.5 Summary 425

For further reading 426

References 426

8 Option Pricing by Monte Carlo Methods 429

8.1 Path generation 430

8.1.2 Simulating hedging strategies 435

8.1.3 Brownian bridge 439

8.2 Pricing an exchange option 443

8.1.1 Simulating geometric Brownian motion 431

CONTENTS xiii

8.3 Pricing a down-and-out put option

8.3.1 Crude Monte Carlo

8.3.2 Conditional Monte Carlo

8.3.3 Importance sampling

Pricing an arithmetic average Asian option

8.4.1 Control variates

8.4.2 Using Halton sequences

Estimating Greeks by Monte Carlo sampling

For further reading

References

8.4

8.5

9 Option Pricing by Finite Diflerence Methods

9.1

9.2

Applying finite diflerence methods to the Black-

Scholes equation

Pricing a vanilla European option by an explicit

method

9.2.1 Financial interpretation of the instability

of the explicit method 481

Pricing a vanilla European option by a fully

implicit method

Pricing a barrier option by the Crank-Nicolson

method

For further reading

References

9.3

9.4

9.5 Dealing with American options

Part I V Advanced Optimization Models and Methods

10 Dynamic Programming

10-1 The shortest path problem

10.2 Sequential decision processes

10.2.1 The optimality principle and solving the

functional equation

10.3 Solving stochastic decision problems by dynamic

programming

10.4 American option pricing by Monte Carlo

simulation

10.4.1 A MATLAB implementation of the least

squares approach

44 6

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44 7

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xiv CONTENTS

10.4.2 Some remarks and alternative approaches

For further reading

References

11 Linear Stochastic Programming Models with Recourse

11.1 Linear stochastic programming models

11.2 Multistage stochastic programming models for

portfolio management

11.2.1 Split-variable model formulation

11.2.2 Compact model formulation

11.2.3 Asset and liability management with

11.3 Scenario generation for multistage stochastic

programming

11.3.1 Sampling for scenario tree generation

11.3.2 Arbitrage free scenario generation

1 1.4 L-shaped method for two-stage linear stochastic

programming

11.5 A comparison with dynamic programming

For further reading

References

transaction costs

12 Non- Convex Optimization

12.1 Mixed-integer programming models

12.1.1 Modeling with logical variables

12.1.2 Mixed-integer portfolio optimization

12.2 Fixed-mix model based on global optimization

12.3 Branch and bound methods for non-convex

optimization

12.3.1 LP-based branch and bound for MILP

models

12.4 Heuristic methods for non-convex optimization

For further reading

References

models

51 9

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54 7

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CONTENTS xv

Part V Appendices

Appendix A Introduction to MATLAB Programming 603

A.l MATLAB environment 603

A.3 MATLAB programming 61 6

Appendix B Refresher on Probability Theory and Statistics 623

A.2 MATLAB graphics 614

B.l Sample space, events, and probability

B.2 Random variables, expectation, and variance

B.2.1 Common continuous random variables

B.3 Jointly distributed random variables

B.4 Independence, covariance, and conditional

expectation

B.5 Parameter estimation

B. 6 Linear regression

For further reading

References

Appendix C Introduction to AMPL

C. 1 Running optimization models in AMPL

C.2 Mean variance eficient portfolios in AMPL

C.3 The knapsack model in AMPL

C.4 Cash pow matching

For further reading

References

Index

623

625

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637

642

64 5

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64 7

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64 9

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657

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