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Publication# Numerical methods for option pricing: polynomial approximation and high dimensionality

Abstract

Options are some of the most traded financial instruments and computing their price is a central task in financial mathematics and in practice. Consequently, the development of numerical algorithms for pricing options is an active field of research. In general, evaluating the price of a specific option relies on the properties of the stochastic model used for the underlying asset price. In this thesis we develop efficient and accurate numerical methods for option pricing in a specific class of models: polynomial models. They are a versatile tool for financial modeling and have useful properties that can be exploited for option pricing.

Significant challenges arise when developing option pricing techniques. For instance, the underlying model might have a high-dimensional parameter space. Furthermore, treating multi-asset options yields high-dimensional pricing problems. Therefore, the pricing method should be able to handle high dimensionality. Another important aspect is the efficiency of the algorithm: in real-world applications, option prices need to be delivered within short periods of time, making the algorithmic complexity a potential bottleneck. In this thesis, we address these challenges by developing option pricing techniques that are able to handle low and high-dimensional problems, and we propose complexity reduction techniques.

The thesis consists of four parts:

First, we present a methodology for European and American option pricing. The method uses the moments of the underlying price process to produce monotone sequences of lower and upper bounds of the option price. The bounds are obtained by solving a sequence of polynomial optimization problems. As the order of the moments increases, the bounds become sharper and eventually converge to the exact price under appropriate assumptions.

Second, we develop a fast algorithm for the incremental computation of nested block triangular matrix exponentials. This algorithm allows for an efficient incremental computation of the moment sequence of polynomial jump-diffusions. In other words, moments of order 0, 1, 2, 3... are computed sequentially until a dynamically evaluated criterion tells us to stop. The algorithm is based on the scaling and squaring technique and reduces the complexity of the pricing algorithms that require such an incremental moment computation.

Third, we develop a complexity reduction technique for high-dimensional option pricing. To this end, we first consider the option price as a function of model and payoff parameters. Then, the tensorized Chebyshev interpolation is used on the parameter space to increase the efficiency in computing option prices, while maintaining the required accuracy. The high dimensionality of the problem is treated by expressing the tensorized interpolation in the tensor train format and by deriving an efficient way, which is based on tensor completion, to approximate the interpolation coefficients.

Lastly, we propose a methodology for pricing single and multi-asset European options. The approach is a combination of Monte Carlo simulation and function approximation. We address the memory limitations that arise when treating very high-dimensional applications by combining the method with optimal sampling strategies and using a randomized algorithm to reduce the storage complexity of the approach.

The obtained numerical results show the effectiveness of the algorithms developed in this thesis.

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Interpolation

In the mathematical field of numerical analysis, interpolation is a type of estimation, a method of constructing (finding) new data points based on the range of a discrete set of known data points.

Pricing

Pricing is the process whereby a business sets the price at which it will sell its products and services, and may be part of the business's marketing plan. In setting prices, the business will take

Financial instrument

Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contra

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