Efficient Options Pricing Using the Fast

Fourier Transform

Yue Kuen Kwok1 , Kwai Sun Leung2 , and Hoi Ying Wong3
1
Hong Kong University of Science and Technology, Hong Kong maykwok@ust.hk
2
The Chinese University of Hong Kong, Hong Kong ksleung@se.cuhk.edu.hk
3
The Chinese University of Hong Kong, Hong Kong hywong@cuhk.edu.hk

1 Introduction
The earliest option pricing models originated by Black and Scholes (1973) and
Merton (1973) use the Geometric Brownian process to model the underlying
asset price process. However, it is well known among market practitioners that
the lognormal assumption of asset price returns suffers from serious deficien-
cies that give rise to inconsistencies as exhibited by smiles (skewness) and term
structures in observed implied volatilities. The earlier remedy to resolve these
deficiencies is the assumption of state and time dependence of the volatility of
the asset price process (see Derman and Kani (1998) and Dupire (1994)). On
the other hand, some researchers recognize the volatility of asset returns as a
hidden stochastic process, which may also undergo regime change. Examples
of these pioneering works on stochastic volatility models are reported by Stein
and Stein (1991), Heston (1993), and Naik (2000). Starting from the seminar
paper by Merton (1973), jumps are introduced into the asset price processes
in option pricing. More recently, researchers focus on option pricing models
whose underlying asset price processes are the Levy processes (see Cont and
Tankov (2004) and Jackson et al. (2008)).
In general, the nice analytic tractability in option pricing as exhibited
by Black-Scholes-Merton’s Geometric Brownian process assumption cannot
be carried over to pricing models that assume stochastic volatility and Levy
processes for the asset returns. Stein and Stein (1991) and Heston (1993)
manage to obtain an analytic representation of the European option price
function in the Fourier domain. Duffie et al. (2000) propose transform methods
for pricing European options under the affine jump-diffusion processes. Fourier
transform methods are shown to be an effective approach to pricing an option
whose underlying asset price process is a Levy process. Instead of applying the
direct discounted expectation approach of computing the expectation integral
that involves the product of the terminal payoff and the density function of
the Levy process, it may be easier to compute the integral of their Fourier
transform since the characteristic function (Fourier transform of the density
2 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong

function) of the Levy process is easier to be handled than the density function
itself. Actually, one may choose a Levy process by specifying the characteristic
function since the Levy-Khinchine formula allows a Levy process to be fully
described by the characteristic function.
In this chapter, we demonstrate the effective use of the Fourier transform
approach as an effective tool in pricing options. Together with the Fast Fourier
transform (FFT) algorithms, real time option pricing can be delivered. The
underlying asset price process as modeled by a Levy process can allow for more
general realistic structure of asset returns, say, excess kurtosis and stochastic
volatility. With the characteristic function of the risk neutral density being
known analytically, the analytic expression for the Fourier transform of the
option value can be derived. Option prices across the whole spectrum of strikes
can be obtained by performing Fourier inversion transform via the efficient
FFT algorithms.
This chapter is organized as follows. In the next section, the mathemati-
cal formulations for building the bridge that links the Fourier methods with
option pricing are discussed. We first provide a brief discussion on Fourier
transform and FFT algorithms. Some of the important properties of Fourier
transform, like the Parseval relation, are presented. We also present the defi-
nition of a Lévy process and the statement of the Lévy-Khintchine formula. In
Sec. 3, we derive the Fourier representation of the European call option price
function. The Fourier inversion integrals in the option price formula can be
associated with cumulative distribution functions, similar to the Black-Scholes
type representation. However, due to the presence of a singularity arising from
non-differentiability in the option payoff function, the Fourier inversion inte-
grals cannot be evaluated by applying the FFT algorithms. We then present
various modifications of the Fourier integral representation of the option price
using the damped option price method and time value method (see Carr and
Madan (1999)). Details of the FFT implementation of performing the Fourier
inversion in option valuation are illustrated. In Sec. 4, we consider the exten-
sion of the FFT techniques for pricing multi-asset options. Unlike the finite
difference approach or the lattice tree methods, the FFT approach does not
suffer from the curse of dimensionality of the option models with regard to an
increase in the number of risk factors in defining the asset return distribution
(see Dempster and Hong (2000) and Hurd and Zhou (2009)). In Sec. 5, we
show how one can price Bermudan style options under Lévy processes using
the FFT techniques by reformulating the risk neutral valuation formulation
as a convolution. We show how the property of the Fourier transform of a con-
volution product can be effectively applied in pricing a Bermudan option (see
Lord et al. (2008)). In Sec. 6, we illustrate an innovative FFT-based network
approach for pricing options under Lévy processes by extending the finite
state Markov chain approach in option pricing. Similar to the forward shoot-
ing grid technique in the usual lattice tree algorithms, the approach can be
adapted to valuation of options with exotic path dependence (see Wong and
Guan (2009)). In Sec. 7, we derive the partial integral-differential equation
 Efficient Options Pricing Using the Fast Fourier Transform 3

formulation that governs option prices under the Lévy process assumption of
asset returns. We then show how to apply the Fourier space time stepping
techniques that solve the partial differential-integral equation for option pric-
ing under Lévy processes. This versatile approach can handle various forms of
path dependence of the asset price process and features / constraints in the
option models (see Jackson et al. (2008)). We present summary and conclusive
remarks in the last section.

2 Mathematical Preliminaries on Fourier Transform

Methods and Lévy Processes
Fourier transform methods have been widely used to solve problems in mathe-
matics and physical sciences. In recent years, we have witnessed the continual
interests in developing the FFT techniques as one of the vital tools in option
pricing. In fact, the Fourier transform methods become the natural math-
ematical tools when we consider option pricing under Lévy models. This is
because a Lévy process Xt can be fully described by its characteristic function
φX (u), which is defined as the Fourier transform of the density function of
Xt .

2.1 Fourier Transform and its Properties

First, we present the definition of the Fourier transform of a function and

review some of its properties. Let f (x) be a piecewise continuous real function
over (−∞, ∞) which satisfies the integrability condition:
Z ∞
|f (x)| dx < ∞.
−∞

The Fourier transform of f (x) is defined by

Z ∞
Ff (u) = eiuy f (y) dy. (1)
−∞

Given Ff (u), the function f can be recovered by the following Fourier inver-
sion formula: Z ∞
1
f (x) = e−iux Ff (u) du. (2)
2π −∞
The validity of the above inversion formula can be established easily via the
following integral representation of the Dirac function δ(y − x), where
Z ∞
1
δ(y − x) = eiu(y−x) du.
2π −∞

Applying the defining property of the Dirac function

4 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong
Z ∞
f (x) = f (y)δ(y − x) dy
−∞

and using the above integral representation of δ(y − x), we obtain

Z ∞ Z ∞
1
f (x) = f (y) eiu(y−x) dudy
−∞ 2π −∞
Z ∞ Z ∞ 
1 −iux iuy
= e f (y)e dy du.
2π −∞ −∞

This gives the Fourier inversion formula (2).

Sometimes it may be necessary to take u to be complex, with Im u 6=
0. In this case, Ff (u) is called the generalized Fourier transform of f . The
corresponding Fourier inversion formula becomes
Z iImu+∞
1
f (x) = e−iux Ff (u) du.
2π iImu−∞
Suppose the stochastic process Xt has the density function p, then the
Fourier transform of p
Z ∞
eiux p(x) dx = E eiuX
 
Fp (u) = (3)
−∞

is called the characteristic function of Xt .

The following mathematical properties of Ff are useful in our later dis-
cussion.
1. Differentiation
Ff ′ (u) = −iuFf (u).
2. Modulation
Feλxf (u) = Ff (u − iλ), λ is real.
3. Convolution
Define the convolution between two integrable functions f (x) and g(x) by
Z ∞
h(x) = f ∗ g(x) = f (y)g(x − y) dy,
−∞

then
Fh = Ff Fg .
4. Parseval relation
Define the inner product of two complex-valued square-integrable func-
tions f and g by Z ∞
< f, g > = f (x)ḡ(x) dx,
−∞
then
1
< f, g > = < Ff (u), Fg (u) > .
2π
 Efficient Options Pricing Using the Fast Fourier Transform 5

We would like to illustrate an application of the Parseval relation in option

pricing. Following the usual discounted expectation approach, we formally
write the option price V with terminal payoff VT (x) and risk neutral density
function p(x) as
Z ∞
−rT
V =e VT (x)p(x) dx = e−rT < VT (x), p(x) > .
−∞

By the Parseval relation, we obtain

e−rT
V = < Fp (u), FVT (u) > . (4)
2π
The option price can be expressed in terms of the inner product of the char-
acteristic function of the underlying process Fp (u) and the Fourier transform
of the terminal payoff FVT (u). More applications of the Parseval relation in
deriving the Fourier inversion formulas in option pricing and insurance can
be found in Dufresne et al. (2009).

2.2 Discrete Fourier Transform

Given a sequence {xk }, k = 0, 1, · · · , N − 1, the discrete Fourier transform of

{xk } is another sequence {yj }, j = 0, 1, · · · , N − 1, as defined by
N −1
X 2πijk
yj = e N xk , j = 0, 1, · · · , N − 1. (5)
k=0

If we write the N -dimensional vectors

x = (x0 x1 · · · xN −1 )T and y = (y0 y1 · · · yN −1 )T ,

and define a N × N matrix F N whose (j, k)th entry is

2πijk
N
Fj,k =e N , 1 ≤ j, k ≤ N,

then x and y are related by

y = F N x. (6)
The computation to find y requires N 2 steps.
However, if N is chosen to be some power of 2, say, N = 2L , the compu-
tation using the FFT techniques would require only 12 N L = N2 log2 N steps.
The idea behind the FFT algorithm is to take advantage of the periodicity
property of the N th root of unity. Let M = N2 , and we split vector x into two
half-sized vectors as defined by

x′ = (x0 x2 · · · xN −2 )T and x′′ = (x1 x3 · · · xN −1 )T .

We form the M -dimensional vectors

6 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong

y′ = F M x′ and y′′ = F M x′′ ,

where the (j, k)th entry in the M × M matrix F M is
2πijk
M
Fj,k =e M , 1 ≤ j, k ≤ M.
It can be shown that the first M and the last M components of y are given
by
2πij
yj = yj′ + e N yj′′ , j = 0, 1, · · · , M − 1,
2πij
yj+M = yj′ −e N yj′′ , j = 0, 1, · · · , M − 1. (7)

Instead of performing the matrix-vector multiplication F N x, we now reduce

the number of operations by two matrix-vector multiplications F M x′ and

2 2
F M x′′ . The number of operations is reduced from N 2 to 2 N2 = N2 . The
same procedure of reducing the length of the sequence by half can be ap-
plied repeatedly. Using this FFT algorithm, the total number of operations is
reduced from O(N 2 ) to O(N log2 N ).

2.3 Lévy Processes

An adapted real-valued stochastic process Xt , with X0 = 0, is called a Lévy
process if it observes the following properties:
1. Independent increments
For every increasing sequence of times t0 , t1 , · · · , tn , the random variables
Xt0 , Xt1 − Xt0 , · · · , Xtn − Xtn−1 are independent.
2. Time-homogeneous
The distribution of {Xt+s − Xs ; t ≥ 0} does not depend on s.
3. Stochastically continuous
For any ǫ > 0, P [|Xt+h − Xt | ≥ ǫ] → 0 as h → 0.
4. Cadlag process
It is right continuous with left limits as a function of t.
Lévy processes are a combination of a linear drift, a Brownian process,
and a jump process. When the Lévy process Xt jumps, its jump magnitude is
non-zero. The Lévy measure w of Xt defined onR R \ {0} dictates how the jump
occurs. In the finite-activity Rmodels, we have R w(dx) < ∞. In the infinite-
activity models, we observe R w(dx) = ∞ and the Poisson intensity cannot
be defined. Loosely speaking, the Lévy measure w(dx) gives the arrival rate
of jumps of size (x, x + dx). The characteristic function of a Lévy process can
be described by the Lévy-Khinchine representation
φX (u) = E[eiuXt ]
!
σ2 2
Z
iux


= exp aitu − tu + t e − 1 − iux1|x|≤1 w(dx)
2 R\{0}

= exp(tψX (u)), (8)

 Efficient Options Pricing Using the Fast Fourier Transform 7

where R min(1, x2 ) w(dx) < ∞, a ∈ R, σ 2 ≥ 0. We identify a as the drift

R

rate and σ as the volatility of the diffusion process. Here, ψX (u) is called the
d
characteristic exponent of Xt . Actually, Xt = tX1 . All moments of Xt can
be derived from the characteristic function since it generalizes the moment-
generating function to the complex domain. Indeed, a Lévy process Xt is
fully specified by its characteristic function φX . In Table 1, we present a list
of Lévy processes commonly used in finance applications together with their
characteristic functions.

Lévy process Xt Characteristic function φX (u)

Finite-activity models
Geometric Brownian motion exp iuµt − 21 σ 2 tu2


1 2 2

Lognormal jump diffusion exp iuµt − 12 σ 2 tu2 + λt(eiuµJ − 2 σJ u − 1)
1 − η 2 iuκ
  
Double exponential jump exp iuµt − 12 σ 2 tu2 + λt e − 1
1 + u2 η 2
diffusion
Infinite-activity models
t
Variance gamma exp(iuµt)(1
 − iuνθ + 21 σ 2 νu2 ) ν 
p p
Normal inverse Gaussian exp iuµt + δt α2 − β 2 − α2 − (β + iu)2
 λt   √ 2  t
α2 − β 2
 2 Kλ δ α −(β+iu)2
Generalized hyperbolic exp(iuµt)  √ 
α2 − (β + iu)2 Kλ δ α2 −β 2
π Iν (z) − I−ν (z)
where Kλ (z) = ,
2 sin(νπ)
 z ν X∞ 2 k
(z /4)
Iν (z) =
2 k=0 k!Γ (ν + k + 1)
exp iuµt − t(iuσ)α sec πα


Finite-moment stable 2
CGMY exp(CΓ (−Y ))[(M − iu)Y − M Y + (G + iu)Y − GY ]
where C, G, M > 0 and Y > 2
Table 1. Characteristic functions of some parametric Levy processes

3 FFT Algorithms for Pricing European Vanilla Options

The renowned discounted expectation approach of evaluating a European op-
tion requires the knowledge of the density function of the asset returns under
the risk neutral measure. Since the analytic representation of the character-
istic function rather than the density function is more readily available for
Lévy processes, we prefer to express the expectation integrals in terms of the
characteristic function. First, we derive the formal analytic representation of
8 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong

a European option price as cumulative distribution functions, like the Black-

Scholes type price formula. We then examine the inherent difficulties in the
direct numerical evaluation of the Fourier integrals in the price formula.
Under the risk neutral measure Q, suppose the underlying asset price
process assumes the form

St = S0 exp(−rt + Xt ), t > 0,

where Xt is a Lévy process and r is the riskless interest rate. We write Y =

log S0 + rT and let FVT denote the Fourier transform of the terminal payoff
function VT (x), where x = log ST . By applying the discounted expectation
valuation formula and the Fourier inversion formula (2), the European option
value can be expressed as (see Lewis (2001))

V (St , t) = e−r(T −t) EQ [VT (x)]

Z iµ+∞
e−r(T −t)

−izx
= EQ e FVT (z) dz
2π iµ−∞

e−r(T −t) iµ+∞ −izx

Z
= e φXT (−z)FVT (z) dz,
2π iµ−∞

where µ = Im z and ΦXT (z) is the characteristic function of XT . The above

formula agrees with (4) derived using the Parseval relation.
In our subsequent discussion, we set the current time to be zero and write
the current stock price as S. For the T -maturity European call option with
terminal payoff (ST − K)+ , its value is given by (see Lewis (2001))
iµ+∞
−Ke−rT e−izκ φXT (−z)
Z
C(S, T ; K) = dz
2π iµ−∞ z 2 − iz
−rT
Z iµ+∞
−Ke i
= e−izκ φXT (−z) dz
2π iµ−∞ z
Z iµ+∞ 
−izκ i
− e φXT (−z) dz
iµ−∞ z−i
1 ∞
  iu log κ  
1 φXT (u − i)
Z
e
=S + Re du
2 π 0 iuφXT (−i)
1 ∞
  iu log κ  
−rT 1 φXT (u)
Z
e
−Ke + Re du , (9)
2 π 0 iu
S
where κ = log K + rT . This representation of the call price resembles the
Black-Scholes type price formula. However, due to the presence of the sin-
gularity at u = 0 in the integrand function, we cannot apply the FFT to
evaluate the integrals. If we expand the integrals as Taylor series in u, the
leading term in the expansion for both integral is O u1 . This is the source

of the divergence, which arises from the discontinuity of the payoff function
 Efficient Options Pricing Using the Fast Fourier Transform 9

at ST = K. As a consequence, the Fourier transform of the payoff function

has large high frequency terms. Carr and Madan (1999) propose to dampen
the high frequency terms by multiplying the payoff by an exponential decay
function.

3.1 Carr-Madan Formulation

As an alternative formulation of European option pricing that takes advan-

tage of the analytic expression of the characteristic function of the underlying
asset price process, Carr and Madan (1999) consider the Fourier transform of
the European call price (considered as a function of log strike) and compute
the corresponding Fourier inversion to recover the call price using the FFT.
Let k = log K, the Fourier transform of the call price C(k) does not exist since
C(k) is not square integrable. This is because C(k) tends to S as k tends to
−∞.

Modified Call Price Method

To obtain a square-integrable function, Carr and Madan (1999) propose to
consider the Fourier transform of the damped call price c(k), where

c(k) = eαk C(k),

for α > 0. Positive values of α are seen to improve the integrability of the
modified call value over the negative k-axis. Carr and Madan (1999) show
that a sufficient condition for square-integrability of c(k) is given by

EQ STα+1 < ∞.
 

We write ψT (u) as the Fourier transform of c(k), pT (s) as the density

function of the underlying asset price process, where s = log ST , and φT (u)
as the characteristic function (Fourier transform) of pT (s). We obtain
Z ∞
ψT (u) = eiuk c(k) dk
−∞
Z ∞ Z s h i
= e−rT pT (s) es+αk − e(1+α)k eiuk dkds
−∞ −∞
−rT
e φT (u − (α + 1) i)
= . (10)
α2 + α − u2 + i(2α + 1)u
The call price C(k) can be recovered by taking the Fourier inversion trans-
form, where

e−αk ∞ −iuk
Z
C(k) = e ψT (u) du
2π −∞
e−αk ∞ −iuk
Z
= e ψT (u) du, (11)
π 0
10 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong

by virtue of the properties that ψT (u) is odd in its imaginary part and even
in its real part [since C(k) is real]. The above integral can be computed using
FFT, the details of which will be discussed next. From previous numerical
experience, usually α = 3 works well for most models of asset price dynamics.
It is important to observe that α has to be chosen such that the denominator
has only imaginary roots in u since integration is performed along real value
of u.

FFT Implementation
The integral in (11) with a semi-infinite integration interval is evaluated by
numerical approximation using the trapezoidal rule and FFT. We start with
the choice on the number of intervals N and the stepwidth ∆u. A numerical
approximation for C(k) is given by
N
e−αk X −iuj k
C(k) ≈ e ψT (uj )∆u, (12)
π j=1

where uj = (j − 1)∆u, j = 1, · · · , N . The semi-infinite integration domain

[0, ∞) in the integral in (11) is approximated by a finite integration domain,
where the upper limit for u in the numerical integration is N ∆u. The error
introduced is called the truncation error. Also, the Fourier variable u is now
sampled at discrete points instead of continuous sampling. The associated
error is called the sampling error. Discussion on the controls on various forms
of errors in the numerical approximation procedures can be found in Lee
(2004).
Recall that the FFT is an efficient numerical algorithm that computes the
sum
N
2π
X
y(k) = e−i N (j−1)(k−1) x(j), k = 1, 2, · · · , N. (13)
j=1

In the current context, we would like to compute around-the-money call option

prices with k taking discrete values: km = −b + (m − 1)∆k, m = 1, 2, · · · , N .
From one set of the FFT calculations, we are able to obtain call option prices
for a range of strike prices. This facilitates the market practitioners to capture
the price sensitivity of a European call with varying values of strike prices. To
effect the FFT calculations, we note from (13) that it is necessary to choose
∆u and ∆k such that
2π
∆u∆k = . (14)
N
A compromise between the choices of ∆u and ∆k in the FFT calculations
is called for here. For fixed N , the choice of a finer grid ∆u in numerical
integration leads to a larger spacing ∆k on the log strike.
The call price multiplied by an appropriate damping exponential factor
becomes a square-integrable function and the Fourier transform of the mod-
ified call price becomes an analytic function of the characteristic function of
 Efficient Options Pricing Using the Fast Fourier Transform 11

the log price. However, at short maturities, the call value tends to the non-
differentiable terminal call option payoff causing the integrand in the Fourier
inversion to become highly oscillatory. As shown in the numerical experiments
performed by Carr and Madan (1999), this causes significant numerical errors.
To circumvent the potential numerical pricing difficulties when dealing with
short-maturity options, an alternative approach that considers the time value
of a European option is shown to exhibit smaller pricing errors for all range
of strike prices and maturities.

Modified Time Value Method

For notational convenience, we set the current stock price S to be unity and
define
Z ∞
zT (k) = e−rT
 k
(e − es )1{s<k,k<0} + (es − ek )1{s>k,k<0} pT (s) ds,

−∞
(15)
which is seen to be equal to the T -maturity call price when K > S and the
T -maturity put price when K < S. Therefore, once zT (k) is known, we can
obtain the price of the call or put that is currently out-of-money while the
call-put parity relation can be used to obtain the price of the other option
that is in-the-money.
The Fourier transform ζT (u) of zT (k) is found to be
Z ∞
ζT (u) = eiuk zT (k) dk
−∞
erT
 
−rT 1 φT (u − i)
=e − − 2 . (16)
1 + iu iu u − iu

The time value function zT (k) tends to a Dirac function at small maturity
and around-the-money, so the Fourier transform ζT (u) may become highly
oscillatory. Here, a similar damping technique is employed by considering the
Fourier transform of sinh(αk)zT (k) (note that sinh αk vanishes at k = 0).
Now, we consider
Z ∞
γT (u) = eiuk sinh(αk)zT (k) dk
−∞
ζT (u − iα) − ζT (u + iα)
= ,
2
and the time value can be recovered by applying the Fourier inversion trans-
form: Z ∞
1 1
zT (k) = e−iuk γT (u) du. (17)
sinh(αk) 2π −∞
Analogous FFT calculations can be performed to compute the numerical ap-
proximation for zT (km ), where
12 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong

1
PN 2π
zT (km ) ≈ π sinh(αkm ) j=1 e−i N (j−1)(m−1) eibuj γT (uj )∆u, (18)
m = 1, 2, · · · , N, and km = −b + (m − 1)∆k.

4 Pricing of European Multi-Asset Options

Apparently, the extension of the Carr-Madan formulation to pricing Euro-
pean multi-asset options would be quite straightforward. However, depending
on the nature of the terminal payoff function of the multi-asset option, the im-
plementation of the FFT algorithm may require some special considerations.
The most direct extension of the Carr-Madan formulation to the multi-
asset models can be exemplified through pricing of the correlation option, the
terminal payoff of which is defined by

V (S1 , S2 , T ) = (S1 (T ) − K1 )+ (S2 (T ) − K2 )+ . (19)

We define si = log Si , ki = log Ki , i = 1, 2, and write pT (s1 , s2 ) as the joint

density of s1 (T ) and s2 (T ) under the risk neutral measure Q. The character-
istic function of this joint density is defined by the following two-dimensional
Fourier transform:
Z ∞Z ∞
φ(u1 , u2 ) = ei(u1 s1 +u2 s2 ) pT (s1 , s2 ) ds1 ds2 . (20)
−∞ −∞

Following the Carr-Madan formulation, we consider the Fourier transform

ψT (u1 , u2 ) of the damped option price eα1 k1 +α2 k2 VT (k1 , k2 ) with respect to
the log strike prices k1 , k2 , where α1 > 0 and α2 > 0 are chosen such that
the damped option price is square-integrable for negative values of k1 and k2 .
The Fourier transform ψT (u1 , u2 ) is related to φ(u1 , u2 ) as follows:

e−rT φ(u1 − (α1 + 1)i, u2 − (α2 + 1)i)

ψT (u1 , u2 ) = . (21)
(α1 + iu1 )(α1 + 1 + iu1 )(α2 + iu2 )(α2 + 1 + iu2 )

To recover CT (k1 , k2 ), we apply the Fourier inversion on ψT (u1 , u2 ). Following

analogous procedures as in the single-asset European option, we approximate
the two-dimensional Fourier inversion integral by
N −1 N −1
e−α1 k1 −α2 k2 X X −i(u1m k1 +u2n k2 )
CT (k1 , k2 ) ≈ e ψT (u1m , u2n )∆1 ∆2 , (22)
(2π)2 m=0 n=0

where u1m = m − N2 ∆1 and u2n = n − N2 ∆2 . Here, ∆1 and ∆2 are the

stepwidths, and N is the number of intervals. In the two-dimensional form of

the FFT algorithm, we define
   
1 N 1 N
kp = p − ∆1 and kq = q − ∆2 ,
2 2
 Efficient Options Pricing Using the Fast Fourier Transform 13

where λ1 and λ2 observe

2π
λ1 ∆1 = λ2 ∆2 = .
N
Dempster and Hong (2000) show that the numerical approximation to the
option price at different log strike values is given by
1 2
e−α1 kp −α2 kq
CT (kp1 , kq2 ) ≈ Γ (kp1 , kq2 )∆1 ∆2 , 0 ≤ p, q ≤ N, (23)
(2π)2
where
N −1 N −1
2πi
X X
Γ (kp1 , kq2 ) = (−1)p+q e− N (mp+nq) (−1)m+n ψT (u1m , u2n ) .
 
m=0 n=0

The nice tractability in deriving the FFT pricing algorithm for the corre-
lation option stems from the rectangular shape of the exercise region Ω of the
option. Provided that the boundaries of Ω are made up of straight edges, the
above procedure of deriving the FFT pricing algorithm still works. This is be-
cause one can always take an affine change of variables in the Fourier integrals
to effect the numerical evaluation. What would be the classes of option payoff
functions that allow the application of the above approach? Lee (2004) lists
4 types of terminal payoff functions that admit analytic representation of the
Fourier transform of the damped option price. Another class of multi-asset
options that possess similar analytic tractability are options whose payoff de-
pends on taking the maximum or minimum value among the terminal values
of a basket of stocks (see Eberlein et al. (2009)). However, the exercise region
of the spread option with terminal payoff

VT (S1 , S2 ) = (S1 (T ) − S2 (T ) − K)+ (24)

is shown to consist of a non-linear edge. To derive the FFT algorithm of similar

nature, it is necessary to approximate the exercise region by a combination
of rectangular strips. The details of the derivation of the corresponding FFT
pricing algorithm are presented by Dempster and Hong (2000).
Hurd and Zhou (2009) propose an alternative approach to pricing the
European spread option under Lévy model. Their method relies on an elegant
formula of the Fourier transform of the spread option payoff function. Let
P (s1 , s2 ) denote the terminal spread option payoff with unit strike, where

P (s1 , s2 ) = (es1 − es2 − 1)+ .

For any real numbers ǫ1 and ǫ2 with ǫ2 > 0 and ǫ1 +ǫ2 < −1, they establish the
following Fourier representation of the terminal spread option payoff function:
Z ∞+iǫ2 Z ∞+iǫ1
1
P (s1 , s2 ) = ei(u1 s1 +u2 s2 ) P̂ (u1 , u2 ) du1 du2 , (25)
(2π)2 −∞+iǫ2 −∞+iǫ1
14 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong

where
Γ (i(u1 + u2 ) − 1)Γ (−iu2 )
P̂ (u1 , u2 ) = .
Γ (iu1 + 1)
Here, Γ (z) is the complex gamma function defined for Re(z) > 0, where
Z ∞
Γ (z) = e−t tz−1 dt.
0

To establish the Fourier representation in (25), we consider

Z ∞Z ∞
P̂ (u1 , u2 ) = e−i(u1 s1 +u2 s2 ) P (s1 , s2 ) ds2 ds1 .
−∞ −∞

By restricting to s1 > 0 and e < es1 − 1, we have

s2

Z ∞ Z log(es1 −1)
P̂ (u1 , u2 ) = e−iu1 s1 e−iu2 s2 (es1 − es2 − 1) ds2 ds1
0 −∞
Z ∞  
1 1
= e−iu1 s1 (es1 − 1)1−iu2 − ds1
0 −iu2 1 − iu2
Z 1  1−iu2
1 iu1 1−z dz
= z ,
(1 − iu2 )(−iu2 ) 0 z z

where z = e−s1 . The last integral can be identified with the beta function:
Z 1
Γ (a)Γ (b)
β(a, b) = = z a−1 (1 − z)b−1 dz,
Γ (a + b) 0

so we obtain the result in (25). Once the Fourier representation of the terminal
payoff is known, by virtue of the Parseval relation, the option price can be
expressed as a two-dimensional Fourier inversion integral with integrand that
involves the product of P̂ (u1 , u2 ) and the characteristic function of the joint
process of s1 and s2 . The evaluation of the Fourier inversion integral can be
affected by the usual FFT calculations (see Hurd and Zhou (2009)). This
approach does not require the analytic approximation of the two-dimensional
exercise region of the spread option with a non-linear edge, so it is considered
to be more computationally efficient.
The pricing of European multi-asset options using the FFT approach re-
quires availability of the analytic representation of the characteristic function
of the joint price process of the basket of underlying assets. One may incor-
porate a wide range of stochastic structures in the volatility and correlation.
Once the analytic forms in the integrand of the multi-dimensional Fourier
inversion integral are known, the numerical evaluation involves nested sum-
mations in the FFT calculations whose dimension is the same as the number
of underlying assets in the multi-asset option. This contrasts with the usual
finite difference / lattice tree methods where the dimension of the scheme in-
creases with the number of risk factors in the prescription of the joint process
 Efficient Options Pricing Using the Fast Fourier Transform 15

of the underlying assets. This is a desirable property over other numerical

methods since the FFT pricing of the multi-asset options is not subject to
this curse of dimensionality with regard to the number of risk factors in the
dynamics of the asset returns.

5 Convolution Approach and Pricing of Bermudan Style

Options
We consider the extension of the FFT technique to pricing of options that
allow early exercise prior to the maturity date T . Recall that a Bermudan
option can only be exercised at a pre-specified set of time points, say T =
{t1 , t2 , · · · , tM }, where tM = T . On the other hand, an American option can
be exercised at any time prior to T . By taking the number of time points
of early exercise to be infinite, we can extrapolate a Bermudan option to
become an American option. In this section, we would like to illustrate how
the convolution property of Fourier transform can be used to price a Bermudan
option effectively (see Lord et al. (2008)).
Let F (S(tm ), tm ) denote the exercise payoff of a Bermudan option at
time tm , m = 1, 2, · · · , M . Let V (S(tm ), tm ) denote the time-tm value of the
Bermudan option with exercise point set T ; and we write ∆tm = tm+1 − tm ,
m = 1, 2, · · · , M − 1. The Bermudan option can be evaluated via the following
backward induction procedure:

terminal payoff: V (S(tM ), tM ) = F (S(tM ), tM )

For m = M − 1, M − 2, · · · , 1, compute
Z ∞
C(S(tm ), tm ) = e−r∆tm V (y, tm+1 )p(y|S(tm )) dy
−∞
V (S(tm ), tm ) = max{C(S(tm ), tm ), F (S(tm ), tm )}.

Here, p(y|S(tm )) represents the probability density that relates the transition
from the price level S(tm ) at tm to the new price level y at tm+1 . By virtue of
the early exercise right, the Bermudan option value at tm is obtained by taking
the maximum value between the time-tm continuation value C(S(tm ), tm ) and
the time-tm exercise payoff F (S(tm ), tm ).
The evaluation of C(S(tm ), tm ) is equivalent to the computation of the
time-tm value of a tm+1 -maturity European option. Suppose the asset price
process is a monotone function of a Lévy process (which observes the indepen-
dent increments property), then the transition density p(y|x) has the following
property:
p(y|x) = p(y − x). (26)
If we write z = y − x, then the continuation value can be expressed as a
convolution integral as follows:
16 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong
Z ∞
C(x, tm ) = e−r∆tm V (x + z, tm+1 )p(z) dz. (27)
−∞

Following a similar damping procedure as proposed by Carr and Madan

(1999), we define
c(x, tm ) = eαx+r∆tm C(x, tm )
to be the damped continuation value with the damping factor α > 0. Applying
the property of the Fourier transform of a convolution integral, we obtain

Fx {c(x, tm )}(u) = Fy {v(y, tm+1 )}(u)φ(−(u − iα)), (28)

and φ(u) is the characteristic function of the random variable z.

Lord et al. (2008) propose an effective FFT algorithm to calculate the
following convolution:
Z ∞
1
c(x, tm ) = e−iux v̂(u)φ(−(u − iα)) du, (29)
2π −∞

where v̂(u) = F {v(y, tm )}. The FFT calculations start with the prescription
of uniform grids for u, x and y:

uj = u0 + j∆u, xj = x0 + j∆x, yj = y0 + j∆y, j = 0, 1, · · · , N − 1.

The mesh sizes ∆x and ∆y are taken to be equal, and ∆u and ∆y are chosen
to satisfy the Nyquist condition:
2π
∆u∆y = .
N
The convolution integral is discretized as follows:
N −1
e−iu0 (x0 +p∆y) X 2π
c(xp ) ≈ ∆u e−ijp N eij(y0 −x0 )∆u φ(−(uj − iα))v̂(uj ), (30)
2π j=0

where
N
X −1
v̂(uj ) ≈ eiu0 y0 ∆y eijn2π/N einu0 ∆y wn v(yn ),
n=0
1
w0 = wN −1 = , wn = 1 for n = 1, 2, · · · , N − 2.
2
For a sequence xp , p = 0, 1, · · · , N − 1, its discrete Fourier transform and the
corresponding inverse are given by
N −1 N −1
X 1 X −ijn2π/N
Dj {xn } = eijn2π/N xn , Dn−1 {xj } = e xj .
n=0
N j=0
 Efficient Options Pricing Using the Fast Fourier Transform 17

By setting u0 = − N2 ∆u so that einu0 ∆y = (−1)n , we obtain

c(xp ) ≈ eiu0 (y0 −x0 ) (−1)p Dp−1 {eij(y0 −x0 )∆u φ(−(uj − iα))Dj {(−1)n wn v(yn )}}.
(31)
In summary, by virtue of the convolution property of Fourier transform,
we compute the discrete Fourier inversion of the product of the discrete char-
acteristic function of the asset returns φ(−(uj − iα)) and the discrete Fourier
transform of option prices Dj {(−1)n wn v(yn )}. It is seen to be more efficient
when compared to the direct approach of recovering the density function by
taking the Fourier inversion of the characteristic function and finding the op-
tion prices by discounted expectation calculations (see Zhylyevsky (2009)).

6 FFT-Based Network Method

As an extension to the usual lattice tree method, an FFT-based network
approach to option pricing under Lévy models has been proposed by Wong
and Guan (2009). The network method somewhat resembles Duan-Simonato’s
Markov chain approximation method (Duan and Simonato (2001)). This new
approach is developed for option pricing for which the characteristic function
of the log-asset value is known. Like the lattice tree method, the network
method can be generalized to valuation of path dependent options by adopting
the forward shooting grid technique (see Kwok (2009)).
First, we start with the construction of the network. We perform the space-
time discretization by constructing a pre-specified system of grids of time and
state: t0 < t1 < · · · < tM , where tM is the maturity date of the option, and
x0 < x1 < · · · < xN , where X = {xj |j = 0, 1, · · · , N } represents the set of
all possible values of log-asset prices. For simplicity, we assume uniform grid
sizes, where ∆x = xj+1 − xj for all j and ∆t = ti+1 − ti for all i. Unlike
the binomial tree where the number of states increases with the number of
time steps, the number of states is fixed in advance and remains unchanged
at all time points. In this sense, the network resembles the finite difference
grid layout. The network approach approximates the Lévy process by a finite
state Markov chain, like that proposed by Duan and Simonato (2001). We
allow for a finite probability that the log-asset value moves from one state
to any possible state in the next time step. This contrasts with the usual
finite difference schemes where the linkage of nodal points between successive
time steps is limited to either one state up, one state down or remains at the
same state. The Markov chain model allows greater flexibility to approximate
the asset price dynamics that exhibits finite jumps under Lévy model with
enhanced accuracy. A schematic diagram of a network with 7 states and 3
time steps is illustrated in Fig. 1.
After the construction of the network, the next step is to compute the
transition probabilities that the asset price goes from one state xi to another
state xj under the Markov chain model, 0 ≤ i, j ≤ N . The corresponding
18 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong

x6 x6 x6 x6

x5 x5 x5 x5

x4 x4 x4 x4

x3 x3 x3 x3

x2 x2 x2 x2

x1 x1 x1 x1

x0 x0 x0 x0

t0 t1 t2 t3

Fig. 1. A network model with 3 time steps and 7 states.

transition probability is defined as follows:

pij = P [Xt+∆t = xj |Xt = xi ], (32)
which is independent of t due to the time homogeneity of the underlying Lévy
process. We define the corresponding characteristic function by
Z ∞
φi (u) = eiuz fi (z|xi ) dz,
−∞

where fi (z|xi ) is the probability density function of the increment Xt+∆t − Xt

conditional on Xt = xi . The conditional probability density function can be
recovered by Fourier inversion:
fi (xj |xi ) = Fu−1 {φi (u)}(xj ). (33)
If we take the number of Markov chain states to be N + 1 = 2L for some
integer L, then the above Fourier inversion can be carried out using the FFT
techniques. The FFT calculations produce approximate values for fi (xj |xi )
for all i and j. We write these approximate conditional probability values
obtained from the FFT calculations as f˜i (xj |xi ). The transition probabilities
among the Markov chain states are then approximated by
f˜i (xj |xi )
p̃ij ≈ PN , 0 ≤ i, j ≤ N. (34)
˜
i=0 fi (xj |xi )
 Efficient Options Pricing Using the Fast Fourier Transform 19

Once the transition probabilities are known, we can perform option valuation
using the usual discounted expectation approach. The incorporation of various
path dependent features can be performed as in usual lattice tree calculations.
Wong and Guan (2009) illustrate how to compute the Asian and lookback op-
tion prices under Lévy models using the FFT-based network approach. Their
numerical schemes are augmented with the forward shooting grid technique
(see Kwok (2009)) for capturing the asset price dependency associated with
the Asian and lookback features.

7 Fourier Space Time Stepping Method

When we consider option pricing under Lévy models, the option price func-
tion is governed by a partial integral-differential equation (PIDE) where the
integral terms in the equation arise from the jump components in the under-
lying Lévy process. In this section, we present the Fourier space time stepping
(FST) method that is based on the solution in the Fourier domain of the gov-
erning PIDE (see Jackson et al. (2008)). This is in contrast with the usual
finite difference schemes which solve the PIDE in the real domain. We discuss
the robustness of the FST method with regard to its symmetric treatment of
the jump terms and diffusion terms in the PIDE and the ease of incorporation
of various forms of path dependence in the option models. Unlike the usual
finite difference schemes, the FST method does not require time stepping cal-
culations between successive monitoring dates in pricing Bermudan options
and discretely monitored barrier options. In the numerical implementation
procedures, the FST method does not require the analytic expression for the
Fourier transform of the terminal payoff of the option so it can deal easier
with more exotic forms of the payoff functions. The FST method can be eas-
ily extended to multi-asset option models with exotic payoff structures and
pricing models that allow regime switching in the underlying asset returns.
First, we follow the approach by Jackson et al. (2008) to derive the gov-
erning PIDE of option pricing under Lévy models and consider the Fourier
transform of the PIDE. We consider the model formulation under the general
multi-asset setting. Let S(t) denote a d-dimensional price index vector of the
underlying assets in a multi-asset option model whose T -maturity payoff is de-
noted by VT (S(T )). Suppose the underlying price index follows an exponential
Lévy process, where
S(t) = S(0)eX(t) ,
and X(t) is a Lévy process. Let the characteristic component of X(t) be the
triplet (µ, M, ν), where µ is the non-adjusted drift vector, M is the covariance
matrix of the diffusion components, and ν is the d-dimensional Lévy density.
The Lévy process X(t) can be decomposed into its diffusion and jump com-
ponents as follows:
X(t) = µ(t) + M W(t) + Jl (t) + lim Jǫ (t), (35)
ǫ→0
20 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong

where the large and small components are

Z tZ
Jl (t) = y m(dy × ds)
0 |y|≥1
Z tZ
Jǫ (t) = y [m(dy × ds) − ν(dy × ds)],
0 ǫ≤|y|<1

respectively. Here, W(t) is the vector of standard Brownian processes, m(dy×

ds) is a Poisson random measure counting the number of jumps of size y
occurring at time s, and ν(dy × ds) is the corresponding compensator. Once
the volatility and Lévy density are specified, the risk neutral drift can be
determined by enforcing the risk neutral condition:

E0 [eX(1) ] = er ,

where r is the riskfree interest rate. The governing partial integral-differential

equation (PIDE) of the option price function V (X(t), t) is given by

∂V
+ LV = 0 (36)
∂t
with terminal condition: V (X(T ), T ) = VT (S(0), eX(T ) ), where L is the in-
finitesimal generator of the Lévy process operating on a twice differentiable
function f (x) as follows:
!
T ∂ ∂ T ∂
Lf (x) = µ + M f (x)
∂x ∂x ∂x
∂
Z
+ {[f (x + y) − f (x)] − yT f (x)1|y|<1 } ν(dy). (37)
Rn \{0} ∂x

By the Lévy-Khintchine formula, the characteristic component of the Lévy

process is given by
1
ψX (u) = iµT u − uT M u
Z  2 
T
+ eiu y − 1 − iuT y1|y|<1 ν(dy). (38)
Rn

Several numerical schemes have been proposed in the literature that solve
the PIDE (36) in the real domain. Jackson et al. (2008) propose to solve the
PIDE directly in the Fourier domain so as to avoid the numerical difficulties
in association with the valuation of the integral terms and diffusion terms.
An account on the deficiencies in earlier numerical schemes in treating the
discretization of the integral terms can be found in Jackson et al. (2008).
By taking the Fourier transform on both sides of the PIDE, the PIDE is
reduced to a system of ordinary differential equations parametrized by the
 Efficient Options Pricing Using the Fast Fourier Transform 21

d-dimensional frequency vector u. When we apply the Fourier transform to

the infinitesimal generator L of the process X(t), the Fourier transform can
be visualized as a linear operator that maps spatial differentiation into multi-
plication by the factor iu. We define the multi-dimensional Fourier transform
as follows (a slip of sign in the exponent of the Fourier kernel is adopted here
for notational convenience):
Z ∞
T
F [f ](u) = f (x)e−iu x dx
−∞

so that ∞
1
Z
T
−1
F [Ff ](u) = Ff eiu x
du.
2π −∞

We observe
∂2
   
∂
F f = iuF [f ] and F f = iu F [f ] iuT
∂x ∂x2

so that
F [LV ](u, t) = ψX (u)F [V ](u, t). (39)
The Fourier transform of LV is elegantly given by multiplying the Fourier
transform of V by the characteristic component ψX (u) of the Lévy process
X(t). In the Fourier domain, F [V ] is governed by the following system of
ordinary differential equations:
∂
F [V ](u, t) + ψX (u)F [V ](u, t) = 0 (40)
∂t
with terminal condition: F [V ](u, T ) = FVT (u, T ).
If there is no embedded optionality feature like the knock-out feature or
early exercise feature between t and T , then the above differential equation
can be integrated in a single time step. By solving the PIDE in the Fourier
domain and performing Fourier inversion afterwards, the price function of a
European vanilla option with terminal payoff VT can be formally represented
by n o
V (x, t) = F −1 F [VT ](u, T )eψX (u)(T −t) (x, t). (41)

In the numerical implementation procedure, the continuous Fourier transform

and inversion are approximated by some appropriate discrete Fourier trans-
form and inversion, which are then effected by FFT calculations. Let vT and
vt denote the d-dimensional vector of option values at maturity T and time
t, respectively, that are sampled at discrete spatial points in the real domain.
The numerical evaluation of vt via the discrete Fourier transform and inver-
sion can be formally represented by

vt = F F T −1 [F F T [vT ]eψX (T −t) ], (42)

22 Yue Kuen Kwok, Kwai Sun Leung, and Hoi Ying Wong

where F F T denotes the multi-dimensional FFT transform. In this numerical

FFT implementation of finding European option values, it is not necessary to
know the analytic representation of the Fourier transform of the terminal pay-
off function. This new formulation provides a straightforward implementation
of numerical pricing of European spread options without resort to elaborate
design of FFT algorithms as proposed by Dempster and Hong (2000) and
Hurd and Zhou (2009) (see Section 4).
Suppose we specify a set of preset discrete time points X = {t1 , t2 , · · · , tN },
where the option may be knocked out (barrier feature) or early exercised
(Bermudan feature) prior to maturity T (take tN +1 = T for notational con-
venience). At these time points, we either impose constraints or perform op-
timization based on the contractual specification of the option. Consider the
pricing of a discretely monitored barrier option where the knock-out feature
is activated at the set of discrete time points X . Between times tn and tn+1 ,
n = 1, 2, · · · , N , the barrier option behaves like a European vanilla option so
that the single step integration can be performed from tn to tn+1 . At time
tn , we impose the contractual specification of the knock-out feature. Say, the
option is knocked out when S stays above the up-and-out barrier B. Let R
denote the rebate paid upon the occurrence of knock-out, and vn be the vec-
tor of option values at discrete spatial points. The time stepping algorithm
can be succinctly represented by

vn = HB (F F T −1 [F F T [vn+1 ]eψX (tn+1 −tn ) ]),

where the knock-out feature is imposed by defining HB to be (see Jackson et

al. (2008))
HB (v) = v1{x<log B } + R1{x≥log B } .
S(0) S(0)

No time stepping is required between two successive monitoring dates.

8 Summary and Conclusions

The Fourier transform methods provide the valuable and indispensable tools
for option pricing under Lévy processes since the analytic representation of the
characteristic function of the underlying asset return is more readily available
than that of the density function itself. When used together with the FFT
algorithms, real time pricing of a wide range of option models under Lévy
processes can be delivered using the Fourier transform approach with high
accuracy, efficiency and reliability. In particular, option prices across the whole
spectrum of strikes can be obtained in one set of FFT calculations.
In this chapter, we review the most commonly used option pricing algo-
rithms via FFT calculations. When the European option price function is
expressed in terms of Fourier inversion integrals, option pricing can be deliv-
ered by finding the numerical approximation of the Fourier integrals via FFT
techniques. Several modifications of the European option pricing formulation
 Efficient Options Pricing Using the Fast Fourier Transform 23

in the Fourier domain, like the damped option price method and time value
method, have been developed so as to avoid the singularity associated with
non-differentiability of the terminal payoff function. Alternatively, the pricing
formulation in the form of a convolution product is used to price Bermudan
options where early exercise is allowed at discrete time points. Depending on
the structures of the payoff functions, the extension of FFT pricing to multi-
asset models may require some ingeneous formulation of the corresponding
option model. The order of complexity in the FFT calculations for pricing
multi-asset options generally increases with the number of underlying assets
rather than the total number of risk factors in the joint dynamics of the un-
derlying asset returns. When one considers pricing of path dependent options
whose analytic form of the option price function in terms of Fourier integrals
is not readily available, it becomes natural to explore various extensions of
the lattice tree schemes and finite difference approach. The FFT-based net-
work method and the Fourier space time stepping techniques are numerical
approaches that allow greater flexibility in the construction of the numerical
algorithms to handle various form of path dependence of the underlying as-
set price processes through the incorporation of the auxiliary conditions that
arise from modeling the embedded optionality features. The larger number
of branches in the FFT-based network approach can provide better accuracy
to approximate the Lévy process with jumps when compared to the usual
trinomial tree approach. The Fourier space time stepping method solves the
governing partial integral-differential equation of option pricing under Lévy
model in the Fourier domain. Unlike usual finite difference schemes, no time
stepping procedures are required between successive monitoring instants in
option models with discretely monitored features.
In summary, a rich set of numerical algorithms via FFT calculations have
been developed in the literature to perform pricing of most types of option
models under Lévy processes. For future research topics, one may consider the
pricing of volatility derivatives under Lévy models where payoff function de-
pends on the the realized variance or volatility of the underlying price process.
Also, more theoretical works should be directed to error estimation methods
and controls with regard to sampling errors and truncation errors in the ap-
proximation of the Fourier integrals and other numerical Fourier transform
calculations.

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