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Finite Explicit

The document discusses pricing European call and put options using the explicit finite difference method. It provides the Black-Scholes prices for a call and put option as examples. It also includes a MATLAB function called finDiffExplicit that implements the explicit finite difference method to price options. The function yields prices close to Black-Scholes when an appropriate time grid is used but can become unstable with a coarser grid.

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62 views2 pages

Finite Explicit

The document discusses pricing European call and put options using the explicit finite difference method. It provides the Black-Scholes prices for a call and put option as examples. It also includes a MATLAB function called finDiffExplicit that implements the explicit finite difference method to price options. The function yields prices close to Black-Scholes when an appropriate time grid is used but can become unstable with a coarser grid.

Uploaded by

hlvijaykumar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Consider pricing a European Call and Put option with the following parameters, X = $60,S0 = $50, r = 5%, = 0.

.2 and T = 1.
The Black-Scholes price for the Call option is $1.624, and the Put option is $8.697
A MATLAB function called finDiffExplicit is given below. The following shows an example of executing finDiffExplicit (and pricing the above option) in MATLAB,
>> cPrice = finDiffExplicit(60,50,0.05,0.2,0:1:100,0:0.001:1,'CALL')
cPrice =
1.621
>> pPrice = finDiffExplicit(60,50,0.05,0.2,0:1:100,0:0.001:1,'PUT')
pPrice =
8.695
The following code confirms that the explicit method can be unstable if the time grid is chosen incorrecly.
>> cPrice = finDiffExplicit(60,50,0.05,0.2,0:1:100,0:0.01:1,'CALL')
cPrice =
7.8572e+045
>> pPrice = finDiffExplicit(60,50,0.05,0.2,0:1:100,0:0.01:1,'PUT')
pPrice =
-6.2721e+033
MATLAB Function: finDiffExplicit
function oPrice = finDiffExplicit(X,S0,r,sig,Svec,tvec,oType)
% Function to calculate the price of a vanilla European
% Put or Call option using the explicit finite difference method
%
% oPrice = finDiffExplicit(X,r,sig,Svec,tvec,oType)
%
% Inputs: X - strike
% : S0 - stock price
% : r - risk free interest rate
% : sig - volatility
% : Svec - Vector of stock prices (i.e. grid points)
% : tvec - Vector of times (i.e. grid points)
% : oType - must be 'PUT' or 'CALL'.
%
% Output: oPrice - the option price
%
% Notes: This code focuses on details of the implementation of the
% explicit finite difference scheme.
% It does not contain any programatic essentials such as error
% checking.
% It does not allow for optional/default input arguments.
% It is not optimized for memory efficiency, speed or
% use of sparse matrces.

% Author: Phil Goddard (phil@goddardconsulting.ca)
% Date : Q4, 2007

% Get the number of grid points
M = length(Svec)-1;
N = length(tvec)-1;
% Get the grid sizes (assuming equi-spaced points)
dt = tvec(2)-tvec(1);

% Calculate the coefficients
% To do this we need a vector of j points
j = 1:M-1;
sig2 = sig*sig;
j2 = j.*j;
aj = 0.5*dt*(sig2*j2-r*j);
bj = 1-dt*(sig2*j2+r);
cj = 0.5*dt*(sig2*j2+r*j);

% Pre-allocate the output
price(1:M+1,1:N+1) = nan;

% Specify the boundary conditions
switch oType
case 'CALL'
% Specify the expiry time boundary condition
price(:,end) = max(Svec-X,0);
% Put in the minimum and maximum price boundary conditions
% assuming that the largest value in the Svec is
% chosen so that the following is true for all time
price(1,:) = 0;
price(end,:) = (Svec(end)-X)*exp(-r*tvec(end:-1:1));
case 'PUT'
% Specify the expiry time boundary condition
price(:,end) = max(X-Svec,0);
% Put in the minimum and maximum price boundary conditions
% assuming that the largest value in the Svec is
% chosen so that the following is true for all time
price(1,:) = (X-Svec(end))*exp(-r*tvec(end:-1:1));
price(end,:) = 0;
end

% Form the tridiagonal matrix
A = diag(bj); % Diagonal terms
A(2:M:end) = aj(2:end); % terms below the diagonal
A(M:M:end) = cj(1:end-1); % terms above the diagonal

% Calculate the price at all interior nodes
offsetConstants = [aj(1); cj(end)];
for i = N:-1:1
price(2:end-1,i) = A*price(2:end-1,i+1);
% Offset the first and last terms
price([2 end-1],i) = price([2 end-1],i) + ...
offsetConstants.*price([1 end],i+1);
end

% Calculate the option price
oPrice = interp1(Svec,price(:,1),S0);

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