Asian Option Pricing

Comparing Different Methods of Pricing

Stratis Frangos











G6505 Course Project
Professor: Irene Hueter



Department of Mathematics

1. Introduction
Options are a type of Financial Derivative. Options are called this way
because its value is derived from the value of the underlying. The underlying
could be a stock, real estate, an index, etc.
Options are utilized by two main players in the financial industry, the
Traders and Hedgers. The 1
st
group uses options mostly to speculate while the
later employs options to reduce the risk of holding an asset.
The most common type of options are the European and American Options.
However, there are many types of other options. To name a few: Bermudan
Options, Barrier Options, Look Back Options, Asian Options.
Asian Options, which is the focus of this project, have their name thanks to
two bankers from Bankers Trust (Standish & Spaughton). They were in Tokyo
in 1987 on business when "they developed the first commercially used pricing
formula for options linked to the average price of crude oil." They called this
exotic option, the Asian option, because they were in Asia
In more general terms, Asian Optins have a payoff that depends on the
average price of the underlying. This must be true for at least for some part of
the option. The complexity of Asian Options lies in the fact that closed-form
formulae doesnot exist. For this very reason, there has been an increased
interested in pricing these options numerically and in the most
efficient/accurate way.


2. Mathematics behind the scene

() is the price of the risk-free asset
() is the price of the risky asset
() is the Standard Brownian Motion
, & are deterministic constants
Price of an asset at time t:
() ()
() () ()

()

According to Girsanovs Theorem there exists a probability measure Q such
that under this measure: (Probability Space ( ) )
() () ()

()
where

()

() (

)
This is Standard Brownian Motion under Q

The solution to the above equation is:
() ()
((

)()(

()

()))

Under Q:
(

())

() ()(

(() ()

()) ()(

()

()
()() is a martingale under Q
Q is a Risk Neutral Measure












3. Pricing Asian Options
There are two types of Asian options:
Fixed-strike
Floating-strike

Payout Formulae
Call Payout (Fixed Strike)
() (( ) )
Put Payout (Fixed Strike)
() ( ( ) )
Call Payout (Floating Strike)
() (() ( ) )
Put Payout (Floating Strike)
() (( ) () )











4. Pricing Methods

The following methods involve some tradeoffs between numerical accuracy
and computational efficiency
Cox, Ross, and Rubinstein (CRR) Pricing
CRR employs working backward in time, evaluating the price of the
option at each node of the binomial tree.
It is possible to price American-style options. However, it is not used
in many situations where payoffs depend on the history of the asset
price as well as its current value.
The main cause is thehistory of the asset is not known when
calculations are carried out at a node

Hull-White Enhanced CRR
Modified Binomial Framework
No constrains on the F-values
This is achieve by computing v(S,F, t) at a node only for certain
predetermined values of F.
















Vorsts Approximation Method
Adjust Strike Price of the option using the Geometric Average

: deal date
n: averaging dates over which the average will be taken.
m: be the number of averaging dates already passed if we have
entered an averaging period.
We can then define the times on which the averaging is done as:

( )





Figure below

is the first averaging date after the deal date

However, time passes and eventually we could have

We count the averages dates we passed and tha is m. Concluding
that n-m average dates are left

Monte Carlo Simulation method
Involves working forward, simulating paths for the asset price.
It can handle options where the payoff is path-dependent.

=T
Levys Approximation Formula
Sum of log-normal distributions is not a log-normal distribution.
However it can be approximated by an alternative distribution
assumed to be log-normal
f(x) denotes the probability function and a(x) the approximating
distribution, a(x): lognormal pdf:
() ()

()

()

()

()


























5. Data Table
T Method (European Call) K=40 K=45 K=50
0.5 [Levy]
[Kemna & Vorst]
[Hull-White extension of CCR]
[Monte Carlo]
10.76522
10.57898
10.75504
10.78941
6.38620
6.21328
6.36312
6.41428
2.89330
3.02436
3.01157
3.06465
1.0 [Levy]
[Kemna & Vorst]
[Hull-White extension of CCR]
[Monte Carlo]
11.57629
11.20628
11.54472
11.64395
7.66152
7.31612
7.61549
7.69258
4.55695
4.26744
4.52205
4.60047
1.5 [Levy]
[Kemna & Vorst]
[Hull-White extension of CCR]
[Monte Carlo]
12.33661
11.78152
12.28462
12.43416
8.737635
8.212933
8.669539
8.796026
5.80113
5.33885
5.74255
5.85667
2.0 [Levy]
[Kemna & Vorst]
[Hull-White extension of CCR]
[Monte Carlo]
13.02437
12.28224
12.95345
13.04102
9.67116
8.96196
9.58174
9.77633
6.874432
6.230249
6.791564
6.946699
s=50, r=10%, sigma=30%, MC: n=100,000, h=0.005
















6. Performance Metrics
T Method (European Call) Runtime in seconds
0.5 [Levy]
[Kemna & Vorst]
[Hull-White extension of CCR]
[Monte Carlo]
Almost Instant
Almost Instant
8.49
25.19
1.0 [Levy]
[Kemna & Vorst]
[Hull-White extension of CCR]
[Monte Carlo]
Almost Instant
Almost Instant
15.35
25.19
1.5 [Levy]
[Kemna & Vorst]
[Hull-White extension of CCR]
[Monte Carlo]
Almost Instant
Almost Instant
21.78
25.16
2.0 [Levy]
[Kemna & Vorst]
[Hull-White extension of CCR]
[Monte Carlo]
Almost Instant
Almost Instant
28.86
25.23

7. Conclusion
After comparing and contrasting the methods above the Hull-Whites
extension to the CRR model seems to be the most efficient/accurate.
Quicker than the MC Method and more accurate than the Levy method
Finally, ancillary benefits to this approach such as the ability to value index
principal swaps & mortgage-backed securities






References
Cox, J., Ross, S., and Rubinstein, M. (1979) Option pricing: A simplified approach
J. Hull, Options, Futures, and other Derivatives, 6th Edition, Pearson
T. Vorst, Prices and Hedge Ratios of Average Exchange Rate Options, International
L. Rogers and Z. Shi: The Value of An Asian Option, Journal of Applied Probability, (
1995)
Tomas Bjork. Arbitrage Theory in Continuous Time. Oxford University Press, 2004.

















Code for Data Table