Abstract
We review the commonly used numerical algorithms for option pricing under Levy process via Fast Fourier transform (FFT) calculations. By treating option price analogous to a probability density function, option prices across the whole spectrum of strikes can be obtained via FFT calculations. We also show how the property of the Fourier transform of a convolution product can be used to value various types of option pricing models. In particular, we show how one can price the Bermudan style options under Levy processes using FFT techniques in an efficient manner by reformulating the risk neutral valuation formulation as a convolution. By extending the finite state Markov chain approach in option pricing, we illustrate an innovative FFT-based network tree approach for option pricing under Levy process. Similar to the forward shooting grid technique in the usual lattice tree algorithms, the approach can be adapted to valuation of options with exotic path dependence. We also show how to apply the Fourier space time stepping techniques that solve the partial differential-integral equation for option pricing under Levy process. This versatile approach can handle various forms of path dependence of the asset price process and embedded features in the option models. Sampling errors and truncation errors in numerical implementation of the FFT calculations in option pricing are also discussed.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
References
Black, F., & Scholes, M. (1973). The pricing of option and corporate liabilities. Journal of Political Economy, 81, 637–659.
Carr, P., & Madan, D. (1999). Option valuation using the fast Fourier transform. Journal of Computational Finance, 2(4), 61–73.
Cont, R., & Tankov, P. (2004). Financial modelling with jump processes. Boca Raton: Chapman and Hall.
Dempster, M. A. H., & Hong, S. S. G. (2000). Spread option valuation and the fast Fourier transform. Technical report WP 26/2000. Cambridge: The Judge Institute of Management Studies, University of Cambridge.
Derman, E., & Kani, T. (1998). Stochastic implied trees: Arbitrage pricing with stochastic term and strike structure of volatility. International Journal of Theoretical and Applied Finance, 1, 61–110.
Duan, J., & Simonato, J. G. (2001). American option pricing under GARCH by a Markov chain approximation. Journal of Economic Dynamics and Control, 25, 1689–1718.
Duffie, D., Pan, J., & Singleton, K. (2000). Transform analysis and asset pricing for affine jump-diffusion. Econometrica, 68(6), 1343–1376.
Dufresne, D., Garrido, J., & Morales, M. (2009). Fourier inversion formulas in option pricing and insurance. Methodology and Computing in Applied Probability, 11, 359–383.
Dupire, B. (1994). Pricing with smile. Risk, 7(1), 18–20.
Eberlein, E., Glau, K., & Papapantoleon, A. (2009). Analysis of Fourier transform valuation formulas and applications. Working paper of Freiburg University.
Heston, S. (1993). A closed-form solution for options with stochastic volatility with applications to bond and currency options. Review of Financial Studies, 6, 327–343.
Hurd, T. R., & Zhou, Z. (2009). A Fourier transform method for spread option pricing. Working paper of McMaster University.
Jackson, K. R., Jaimungal, S., & Surkov, V. (2008). Fourier space time-stepping for option pricing with Levy models. Journal of Computational Finance, 12(2), 1–29.
Kwok, Y. K. (2010). Lattice tree methods for strongly path dependent options. Encyclopedia of Quantitative Finance, Cont R. (ed.), John Wiley and Sons Ltd, 1022–1027.
Lee, R. (2004). Option pricing by transform methods: Extensions, unification, and error control. Journal of Computational Finance, 7(3), 51–86.
Lewis, A. L. (2001). A simple option formula for general jump-diffusion and other exponential Levy processes. Working paper of Envision Financial Systems and OptionsCity.net, Newport Beach, California.
Lord, R., Fang, F., Bervoets, F., & Oosterlee, C. W. (2008). A fast and accurate FFT-based method for pricing early-exercise options under Lévy processes. SIAM Journal on Scientific Computing, 30, 1678–1705.
Merton, R. (1973). Theory of rational option pricing. Bell Journal of Economics and Management Sciences, 4, 141–183.
Merton, R. (1976). Option pricing when the underlying stock returns are discontinuous. Journal of Financial Economics, 3, 125–144.
Naik, V. (2000). Option pricing with stochastic volatility models. Decisions in Economics and Finance, 23(2), 75–99.
Stein, E., & Stein, J. (1991). Stock price distribution with stochastic volatility: An analytic approach. Review of Financial Studies, 4, 727–752.
Wong, H. Y., & Guan, P. (2009). An FFT network for Lévy option pricing. Working Paper of The Chinese University of Hong Kong.
Zhylyevsky, O. (2010). A fast Fourier transform technique for pricing American options under stochastic volatility. Review of Derivatives Research, 13, 1–24.
Acknowledgements
This work was supported by the Hong Kong Research Grants Council under Project 642110 of the General Research Funds.
Author information
Authors and Affiliations
Corresponding author
Editor information
Editors and Affiliations
Rights and permissions
Copyright information
© 2012 Springer-Verlag Berlin Heidelberg
About this chapter
Cite this chapter
Kwok, Y.K., Leung, K.S., Wong, H.Y. (2012). Efficient Options Pricing Using the Fast Fourier Transform. In: Duan, JC., Härdle, W., Gentle, J. (eds) Handbook of Computational Finance. Springer Handbooks of Computational Statistics. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-17254-0_21
Download citation
DOI: https://doi.org/10.1007/978-3-642-17254-0_21
Published:
Publisher Name: Springer, Berlin, Heidelberg
Print ISBN: 978-3-642-17253-3
Online ISBN: 978-3-642-17254-0
eBook Packages: Mathematics and StatisticsMathematics and Statistics (R0)