Power Option Pricing via Fast Fourier Transform

Siti N. Ibrahim

, John G. OHara

Center for Computational Finance & Economic Agents

University of Essex, Wivenhoe Park, Colchester CO4 3SQ
sniibr@essex.ac.uk

,johara@essex.ac.uk

Nick Constantinou
Essex Business School
University of Essex, Wivenhoe Park, Colchester CO4 3SQ
nconst@essex.ac.uk
AbstractThe basis of the option universe has been the
European option, and much literature has been devoted to the
extension of this option to create many new exotic options,
including some with nonlinear payoffs. In this work, we study a
European-style power option pricing, under a constant volatility
dynamics, using the risk-neutral valuation within the Black-
Scholes framework. Apart from applying the closed-form solu-
tion, we price the power option using the Fast Fourier Transform
(FFT) technique which requires an analytical characteristic
function of the power option. The resulting approximations are
then compared with other numerical methods such as the Monte
Carlo simulations, which show promising results and demonstrate
the efciency of the FFT technique as it can compute option
prices for a whole range of strike prices. Besides, we show that
there exists a relationship between the power call option and the
power put option that is similar to the put-call parity relationship
of vanilla options. We also nd a transformation between the
underlying asset and the power contract which enables us to
obtain the pricing formulas of the power options from the vanilla
options, as well as simplify the Greeks for power options. In
addition to the Greeks derived from the closed-form solution, we
present the Greeks using the pricing formula obtained from a
characteristic function.
I. INTRODUCTION
Options have been used and improved extensively since they
were rst introduced. Each time new options emerge, most
of these are exotic options, also referred to as non-standard
options because the payoffs are different than the payoff of a
standard vanilla option. One such option is the power option,
and there is lack of analysis on this type of option.
There are a number of variations on the simple option payoff
which rely on the power of the underlying. These are known
as power options. These options are typied by signicant
leverage; a small change in the value of the underlying leads
to signicant changes in the value of the power option (see
1; 2). In (3) and (4), they provide a closed-form formula for
power options, and show that power options can be hedged
with a package of standard vanilla options. Additionally, (5)
have studied power options within a general class of nonlinear
payoffs.
In a recent study, (6) shows that the solution to a special
model for hedging strategies in an illiquid markets is identical
to the structure of a power option. In addition, the structure of
a power call option is very similar to the payoff of a Constant
Proportional Portfolio Insurance (CPPI) strategy, a portfolio
insurance strategy that involves dynamically trading a risky
asset, such as stocks, and a risk-free asset, such as government
bonds (see 7; 8). The payoff of the CPPI strategy depends on
the terminal value of the risky asset raised to a positive power.
The CPPI strategy is a signicant strategy within the structured
product market that has recently come to the attention of
nancial regulators (9) following the subprime crisis.
In this work, we employ three methods in pricing the power
options. The rst approach uses the closed-form solution
which is obtained using the risk-neutral valuation method,
similar to the Black-Scholes framework (10). The second ap-
proach utilizes the widely-used Monte Carlo simulation (11),
as a benchmark to compare the efciency of these methods.
Finally, the third approach is the Fast Fourier Transform (FFT)
technique which was rst introduced by (12) to obtain the
Discrete Fourier Transform (DFT) and its inverse. Implement-
ing the DFT involves N points where for added efciency,
the value N is a power of 2 and it is essential to have an
extensively large N data set. This reduces the number of
computations from O(N
2
) to O(N ln N). For an introduction
to the method of FFT in nance, see (13).
The rst application of the FFT technique to option pricing
was presented in the seminal work of (14), and has gained
popularity in the literature of option pricing (see 15; 16; 17).
In option pricing, to implement this technique, it is important
to have an analytical characteristic function of the stock
price process. The technique transforms the probability density
function of the options; thus making it a exible option
pricing method where we are able to encapsulate properties
such as stochastic volatility and mean-reversion, whilst still
maintaining its exceptional computational efciency. Besides,
this approach gives an insight to the behaviour of the option
prices as a function of the strike prices, which is a signicant
advantage of the method as simple linear interpolation can
be used to obtain the desired price for any given strike;
hence improving the speed of calculation in option pricing.
Following their work (see 14), much literature has extended
this method to price other types of options, specically exotic
options, such as spread options (18) and Asian options (19).
II. CLOSED-FORM SOLUTION OF A POWER OPTION
In this section we present the mathematical foundation of
the derivation of the closed-form solution for a power option
within the Black-Scholes environment. Under risk-neutrality,
the underlying asset price, S
t
, is assumed to follow the process
dS
t
= rS
t
dt + S
t
dW
t
(II.1)
2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK
978-1-4673-2666-7/12/$31.00 2012 IEEE 1
where r is a risk-free rate, is a (constant) volatility of the
asset price log returns, and W
t
is a standard Brownian motion.
The Black-Scholes formula for the prices of a vanilla call
option, C, and vanilla put option, P, on the underlying with
time to maturity, and strike price, K are given by:
C = S
t
N(d
1
) Ke
r
N(d
2
) (II.2)
P = Ke
r
N(d
2
) S
t
N(d
1
). (II.3)
where N(.) is the standard cumulative normal distribution
function, and
d
1
=
ln(
St
K
) + (r +
1
2

2
)

, (II.4)
d
2
= d
1

. (II.5)
Following that, the vanilla call and put options satisfy the put-
call parity relationship:
C + Ke
r
= P + S
t
. (II.6)
Similar to a vanilla option, a power call option gives its holder
the right but not the obligation to buy multiple units of asset
for a strike price at maturity; whereas a power put option gives
its holder the right but not the obligation to sell multiple units
of asset at maturity, for a strike price. The payoff function for
a power call option, PC, and a power put option, PP, are as
follows:
PC
Payoff
= max(S

T
K, 0), (II.7)
PP
Payoff
= max(K S

T
, 0). (II.8)
The similarity between the vanilla and power options enables
us to follow closely the derivation of a vanilla option within
the Black-Scholes environment, under risk-neutrality. Suppose
f = ln S

t
. Using It os lemma, we determine that the process
followed by f is given by:
d(ln S

t
) = (r
1
2

2
) dt + dW
t
. (II.9)
This demonstrates that f = ln S

t
follows a generalized
Wiener process with a constant drift (r
1
2

2
), and a constant
volatility . Therefore, the change in f = ln S

t
for some
time is normally distributed with mean (r
1
2

2
), and
variance
2

2
. Mathematically,
ln S

ln S

t
+ (r
1
2

2
),
2

. (II.10)
Hence S

T
has a log-normal distribution. In a risk-neutral
world, the price of a power call option is computed as the
discounted risk-neutral conditional expectation of the terminal
payoff (II.7) at a risk-free rate r :
PC = e
r
E
Q
[max(S

T
K, 0)] (II.11)
= S

t
e
(1)(r+
1
2

2
)
N(d
1,
)
Ke
r
N(d
2,
). (II.12)
Analogously, given the terminal payoff (II.8), the power put
price is:
PP = e
r
E
Q
[max(K S

T
, 0)] (II.13)
= Ke
r
N(d
2,
)
S

t
e
(1)(r+
1
2

2
)
N(d
1,
), (II.14)
where
d
1,
=
ln(
S

t
K
) + (r
1
2

2
+
2
)

, (II.15)
d
2,
= d
1,

. (II.16)
If = 1, the closed-form solutions (II.12) and (II.14)
become the closed-form solution for a vanilla call and put
option, respectively. Additional to that, an integral element of
Equation (II.12) and Equation (II.14) is
S
t,
= S

t
e
(1)(r+
1
2

2
)
, (II.17)
which (20) refers to as a power contract with unit strike, and
acts like the underlying of a power option. The following
lemma provides the power put-power call parity relationship
which employs a similar approach to the put-call parity
relationship given in (II.6):
Lemma II.1 (Power Put-Power Call Parity Relationship).
PC + Ke
r
= PP + S

t
e
(1)(r+
1
2

2
)
. (II.18)
Hence, Lemma II.1 implies that a portfolio consisting of
a power call option and cash is equivalent to a portfolio
consisting of a power put option and a power contract. As far
as the authors are aware, this relationship is new. The proof
to Lemma II.1 is straightforward.
According to (21), options on the power of the underlying
can be obtained from a vanilla option by an appropriate
adjustment of the underlying, interest rates and volatility.
However, we generalize this transformation by considering
the power contract. This transformation results in a compact
representation of the prices of the power option, their Greeks,
and in particular, the so-called power put-power call parity
relationship. For that reason, we come to the following lemma:
Lemma II.2 (Vanilla-Power Transformation). Consider the
following transformations:
S
t
S
t,
= S

t
e
(1)(r+
1
2

2
)
, (II.19)

= . (II.20)
Thus, given the pricing formulas for a vanilla call option, C,
and a vanilla put option, P, we can obtain the pricing formulas
for a power call option, PC, and a power put option, PP,
using the transformations (II.19) and (II.20). For notational
brevity, let C(S
t
S
t,
;

) = C(), and P(S

t

S
t,
;

) = P(). Mathematically, we can show that:

PC = C(), (II.21)
PP = P(). (II.22)
2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK
2
and it is straightforward on noting that:
d
1,
= d
1
(), (II.23)
d
2,
= d
2
(). (II.24)
Consequently, using Lemma II.2, yields Lemma II.1:
C() + Ke
r
= P() + S
t
(). (II.25)
We nally note that similar to the vanilla options, the
power options satisfy the following useful symmetry relation-
ships (see 20):
PC(S

t
, K, , r, ) = PP(S

t
, K, , r, ),
b PC(S

t
, K, , r, ) = PC(b S

t
, b K, , r, ),
PC(S

t
, K, , r, ) = PP(S

t
, K, , r, ),
PP(S

t
, K, , r, ) = PC(S

t
, K, , r, ).
III. POWER OPTION PRICING USING THE FFT
The essence behind the FFT approach is the characteris-
tic function of the stochastic process. Provided that this is
obtained analytically, we can use this approach to price the
options. The characteristic function is dened as follows:
Denition III.1 (Characteristic Function). For a one-
dimensional stochastic process X
t
, 0 t T, the charac-
teristic function is the Fourier transform of the probability
density function q
T
(X
T
) given as follows:
(v) = E
Q
(e
ivX
T
) =

e
ivX
T
q
T
(X
T
) dX
T
. (III.1)
Let (, F, Q) be a probability space on which is dened
a Brownian motion, W
t
, 0 t T, a ltration generated
by the Brownian motion, F
t
, 0 t T, and a risk-neutral
probability, Q. It os Lemma implies that S

T
is also a geometric
Brownian motion (4; 2), that follows:
dS

t
= (r +
1
2

1
2

2
)S

t
dt + S

t
dW
t
. (III.2)
Suppose that the asset price follows a lognormal process, then
we have:
d(ln S

t
) = (r
1
2

2
) dt + dW
t
. (III.3)
Let s = ln S

T
and k = ln K. It follows that the lognormal
asset price probability density function is given as follows:
q
T
(s
T
) =
1

2
e

(
s[s+(r
1
2

2
)]
)
2
2
2

. (III.4)
Consequently, we obtain the following characteristic function
for the log-normal asset price for a power option:

(v) = e
iv[s+(r
1
2

2
)]
1
2
(

v)
2
. (III.5)
On that account, and Lemma II.2, we have the following:
Lemma III.1 (Characteristic Function via Vanilla-Power
Transformation). Using the Vanilla-Power Transformation, the
characteristic function for a power option,

(v), is obtain-
able from the characteristic function of a vanilla option, (v),
that is:
(v)() =

(v). (III.6)
Let K be the strike price and be the time to maturity of a
power option with terminal asset price S

T
, which is governed
by the dynamics given in (III.2). From here on, we consider
the power call option as the power put option is obtainable in
a similar way. We dene X
t
= ln S
t
and k =
ln K

. Moreover,
we express the option pricing function (II.11) as a function of
the log strike k instead of the terminal log asset price X
T
,
PC
T
(k) = e
r

k
(e
X
T
e
k
)f
T
(X
T
) dX
T
, (III.7)
where f
T
(X
T
) is the density function of the process X
T
.
Following (14), for > 0, we dene a modied power call
price,

PC
T
(k) = e
k
PC
T
(k), (III.8)
where the Fourier Transform (FT) of

PC
T
(k) is given by:
F

(v) =

e
ivk

PC
T
(k) dk. (III.9)
Applying the inverse FT to (III.9), then substituting (III.8)
with (III.7) into (III.9), and also by the denition of the
characteristic function (III.1), we obtain the price of a power
call option as follows:
PC
T
(k) =
e
k
2

e
ivk
F

(v) dv, (III.10)

where
F

(v) = e
r

[v i( + 1)]
( + iv)( + iv + 1)
. (III.11)
Thus for an efcient implementation of the FFT, a closed-form
representation of the characteristic function

(v) is required,
which we have shown earlier, has the form of (III.5). Given the
pricing function (III.10), we can price the power call option
as follows:
PC
T
(k
u
) =
e
ku

j=1
e
i
2
N
(j1)(u1)
e
ibvj
F

(v
j
)

3
[3 + (1)
j

j1
], (III.12)
where v
j
= (j 1), k
u
= b + (u 1), b =
N
2
, =
2
N
, and
n
is the Kronecker delta function which is unity for
n = 0 and zero otherwise. The choice of and is essential
because it governs this approach. A small gives us a range
of prices across a wide range of strike prices; while a large
value of can give inaccurate prices. Moreover, the FFT is an
algorithm that evaluate the summations of the following form
efciently:
X(k) =
N

j=1
e
i
2
N
(j1)(k1)
x(j), k = 1, . . . , N (III.13)
with x(j) = e
ibvj
F

(v
j
)

3
[3 + (1)
j

j1
]. Hence, the
2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK
3
presentation of the power call price in the form (III.12) is
a special case of (III.13) which enables the use of the FFT.
IV. THE GREEKS
In this section, we present the Greeks Delta (), Gamma
(), Rho (), Theta (), and Vega () for the power
option obtained from the closed-form solution as given in
Section II, and also from the pricing formula obtained via
the characteristic function as shown in Section III.
A. Using the Closed-Form Solution
Given the closed-form solution for a power call op-
tion (II.12), the sensitivity measures are as follows:

PC
=

S
t
S
t,
N(d
1,
),

PC
=

(S
t
)
2
S
t,
[( 1)N(d
1,
+
1

(d
1,
)],

PC
=

S
t,
( 1)N(d
1,
) + Ke
r
N(d
2,
)

PC
= S
t,
[( 1)(r +
1
2

2
)N(d
1,
)

(d
1,
)] rKe
r
N(d
2,
),

PC
= S
t,
[(
2
)N(d
1,
) +

(d
1,
)].
The Greeks of a power put option can be obtained from the
Greeks of the power call option using the power put-power call
parity relationship as shown in Lemma II.1. Consequently, we
present the Greeks of the power contract (II.17) in the usual
manner, given by the following lemma::
Lemma IV.1 (The Greeks of a Power Contract). Given the
power contract S
t,
, the associated Greeks are as follows:

=

S
t
S
t,
=

S
t
S
t,
, (IV.1)

=

2
S
2
t
S
t,
=
1
S
t

, (IV.2)

=

r
S
t,
= ( 1)S
t,
, (IV.3)

=

t
S
t,
= ( 1)(r +
1
2

2
)S
t,
, (IV.4)

S
t,
= ( 1)S
t,
. (IV.5)
Besides, in conjunction with Lemma II.2, the Greeks for
the power option can be succinctly expressed via the Greeks
of the power contract and the Greeks of the vanilla options.
The following lemma shows the transformation:
Lemma IV.2 (The Greeks Using Vanilla-Power Transforma-
tion). Given the Greeks of a power contract and the Greeks of
a vanilla call option, C, the Greeks of the power call option,
PC, can be presented as the following:

PC
=
C
()

, (IV.6)

PC
=
C
()
2

+
C
()

, (IV.7)

PC
=
C
() +
C
()

, (IV.8)

PC
=
C
() +
C
()

, (IV.9)

PC
=
C
() +
C
()

. (IV.10)
Note that the transformation produces equivalent expressions
for the Greeks of the power put option.
B. Using the FFT based Pricing Formula
In Section III, we provide an analytical characteristic func-
tion of a power option. (22) uses the price of a vanilla option
obtained from its characteristic function to derive delta and
gamma of the option. Thus, using Equation (III.10), we extend
this to derive the Greeks for the power call option as follows:

PC
=
e
k

S
t

0
e
ivk
e
r

[v i( + 1)]
( + iv)
dv,

PC
=
e
k

(S
t
)
2

0
e
ivk
e
r
(( + iv + 1) 1)

[v i( + 1)]
( + iv)
dv,

PC
=
e
k

0
e
ivk
e
r
(i[v i( + 1)] 1)

[v i( + 1)]
( + iv)
dv,

PC
=
e
k

0
e
ivk
e
r
{r + ri[v i( + 1)]

1
2

2
i[v i( + 1)]
1
2

2
[v i( + 1)]
2
}

[v i( + 1)]
( + iv)
dv,

PC
=
e
k

0
e
ivk
e
r
[v i( + 1)]
{i [v i( + 1)]}

[v i( + 1)]
( + iv)
dv.
The equivalent Greeks for the power put option may be
obtained from the power put-power call parity relationship.
V. NUMERICAL RESULTS
In this section, we present the computational result of the
prices of the power call option. We price the power call option
using the closed-form solution obtained within the Black-
Scholes environment, the FFT pricing formula, and the Monte
Carlo (MC) simulation.
1
Table I documents the prices of a power call option across
a range of strikes and maturities with S = 10, r = 0.02,
and = 0.2, using the closed-form solution. While Table II
documents the prices obtained using the FFT and the Monte
1
The computations were implemented in MATLAB and conducted on an
Intel Core 2 Duo processor P8400 @ 2.26 GHz machine running under
Windows Vista Service Pack 2 with 2GB RAM.
2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK
4
Carlo simulation approach. For the FFT approach, we take
= 0.25, N = 2
10
and = 0.75. In addition, we take
N = 500, 000 simulations to price the power call option
using the Monte Carlo simulation approach. It can be seen that
the prices obtained from these three methods are perfect. The
closed-form solution gives the prices almost instantaneously.
However, our purpose is to show the efciency of the FFT
technique over the Monte Carlo simulation approach. Taking
the Monte Carlo simulation as the benchmark, from Table II,
we see that the FFT technique gives accurate approximation
prices since the percentage difference (taken relative to the
FFT prices) between the prices are less than one percent.
Moreover, the FFT technique is efcient as it takes, on average,
0.00173925 seconds to produce the prices of the power call
option; whereas the Monte Carlo simulation takes 0.12466025
seconds, on average. This shows that the FFT technique
is almost a hundred percent faster than the Monte Carlo
simulation technique.
TABLE I
PRICES OF A POWER CALL OPTION USING THE CLOSED-FORM SOLUTION
Strike, K T (years) Analytic
50 0.5 53.5730
50 1 57.4619
50 1.5 61.5987
75 0.5 30.2920
75 1 36.0529
75 1.5 41.5097
100 0.5 13.4945
100 1 20.5851
100 1.5 26.7456
125 0.5 4.9558
125 1 11.0876
125 1.5 16.8614
Figure 1 shows the comparison of the three methods we
employ in pricing the power call option with = 2. The
margin is so small that the graph ts almost perfectly to each
other. Additionally, we show in Figure 2 that a power call can
be replicated using a package of vanilla calls; for instance,
a power call with an underlying S = 25, can be replicated
with a package of 121 vanilla calls. Meanwhile in Figure 3,
we observe that the delta and gamma of a power call and a
vanilla call share the same shape, except that the values are
heightened for the power call.
VI. CONCLUSION
The FFT method has found wide applications in many elds.
In this paper, the fundamental premise was to investigate the
valuation of a European-style power option using the closed-
form solution within the Black-Scholes environment, and the
TABLE II
PRICES OF A POWER CALL OPTION USING THE FAST FOURIER
TRANSFORM AND THE MONTE CARLO SIMULATION
Strike, K T (years) MC FFT Difference (%)
50 0.5 53.5692 53.5670 0.004107
50 1 57.4705 57.4565 0.024360
50 1.5 61.5994 61.5936 0.009416
75 0.5 30.3249 30.2892 0.117725
75 1 36.0173 36.0500 0.090790
75 1.5 41.3348 41.5067 0.415872
100 0.5 13.4910 13.4980 0.051886
100 1 20.6567 20.5857 0.343714
100 1.5 26.8525 26.7448 0.401080
125 0.5 4.9236 4.9592 0.723048
125 1 11.1136 11.0889 0.222250
125 1.5 16.8566 16.8615 0.029069
TABLE III
RUNNING-TIME COMPARISON FOR PRICING A POWER CALL OPTION FOR
T = 1.
Strike, K MC (seconds) FFT (seconds)
50 0.178384 0.003852
75 0.068980 0.001444
100 0.081065 0.001474
125 0.078022 0.001555
Fig. 1. Power Call Prices Using the Closed-Form Solution, Fast Fourier
Transform and Monte Carlo Simulation for Different Maturities.
FFT technique. We choose the FFT method to price the power
call option because it is exible and reliably fast. This is
proven in the numerical results by comparing this approach
to the Monte Carlo simulation technique.
Not only do we demonstrate the method of pricing a power
option, we also show that there exists a power put-power call
parity relationship which follows a similar approach to the
2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK
5
Fig. 2. Power Call Replicated with Vanilla Calls using K = 20, = 2.
Fig. 3. Comparison of the Delta and Gamma for a Power Call and a Vanilla
Call.
put-call parity relationship. Following that, we show that the
pricing formula can easily be obtained in a concise way from
a vanilla option via a transformation that involves a power
contract and a scaled volatility. Using the same transformation,
we can obtain a concise form of the Greeks of a power option
which are derived from the closed-form solution. Besides, we
provide another way to present the Greeks of the power option,
that is by deriving the pricing formula of the power option
obtained using the characteristic function.
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