Topics in Continuous-Time Finance; Spring 2003

Rolf Poulsen
November 26, 2002

Aim
Backward looking: Acquire proficiency in the use of the continuous-time techniques learned
in Matematisk Finansieringsteori.
Hands-on/General to specific.
Extensions of MF models.
Forward looking: Acquire a non-trivial information set regarding topics & techniques for
further studies. (Possible thesis topics, in short.)

Topics

Seydel (2002) is the only book youll need to buy. Many of the articles are electronically available
through my homepage. Take a look at
http://www.math.ku.dk/rolf/teaching/thesis/menu.html
if you are curious.

2.1

A Numerical Toolbox

Numerical solution of parabolic PDEs. Explicit and implicit finite difference method, in particular the Crank-Nicolson method. Accuracy; stability; implementation; global order determination, extrapolation. Seydel (2002)[Chapter 4].
Pricing by Monte Carlo methods. Variance reduction techniques. Seydel (2002)[Chapters 2 &
3].
Simulation of diffusion processes. Euler-, Milshtein-, and higher-order-schemes. Efficiency
trade-offs in relation to MC-pricing. Seydel (2002)[Chapter 2], Duffie (2001)[Sections 12D-G].

2.2

Interest Rates Models

Hands-on-data: Estimation of the term structure. Basic time series behaviour: Volatility
structures, # driving factors. Common 1-factor models (revisited): CIR & Vasicek, Bj
ork
(1998)[Chapter 17]. Quick & dirty parameter estimation (3 risk-premium), calibration.
Multi-factor diffusion models. Affine models (Duffie & Kan (1996), Dai & Singleton (2000)),
LIBOR market models (Brace, Gatarek & Musiela (1997), Miltersen, Sandmann & Sondermann (1997), non-nonsense-notes).
Interest rate options: Caps & floors (Bj
ork (1998)[Chapter 19]). Swaptions & options on
coupon-bearing bonds: Prices, Jamshidian (1989), Geman, El-Karoui & Rochet (1995), notes/exercises.
Approximations, Munk (1999).
Mortgage backed securities. School I: Option pricing approach, possibly subject to imperfections, Stanton (1995) School II: Empirical prepayment models; Option Adjusted Spreads.
Richard & Roll (1989), Jakobsen (1992), Chen (1996).

2.3

Extensions of the Black/Scholes Model

Hands-on-data: Empirical fallacies of B/S. Non-constant (stochastic, clustered) volatility,

heavy tails, implied volatility smiles.
Complete market solution: CEV-model, 21 -trick pony, but used Schroder (1989), Andersen
& Andreasen (2000). Local volatility surface models as in Dupire (1994), Derman & Kani
(1994), Andersen & Brotherton-Ratcliffe (1998) and many others. 1-trick pony; forward
volatility problem.
Stochastic volatility models. Hull & White (1987), Heston (1993). Maybe Duans GARCHformulation. Gloves-are-off-approach in Wilmott (1998)[Chapter 23].
Jump diffusion: Merton (1976). Gloves-are-off-approach in Wilmott (1998)[Chapter 26] .

2.4

Exotic Options

American options. PDEs (all the way back to Brennan & Schwartz (1977)); improved binomials
(Leisen (1999)); simulation (Longstaff & Schwartz (2001)).
Barriers and lookbacks, Rubinstein & Reiner (1991), Bj
ork (1998)[Chapter 13]. Static hedging,
Derman, Ergener & Kani (1995), Carr & Chou (1997), Carr, Ellis & Gupta (1998), notes.
Asian options. Kemna & Vorst (1990), Alziary, Dechamps & Koehl (1997), Rogers (1995), ad
nausiam.
2

 Passport options. Andersen, Andreasen & Brotherton-Ratcliffe (1998), Wilmott (1998)[Chapter 18].

Evaluation

There are several unknown factors, but passing will in one way or another require active participation during the semester. One possibility: 3-4 minor written assignments (concrete questions; real
deadlines). Oral exam: does not seem natural. Student presentations: Inefficient. Large paper at
the end: Then you might as well write a fagprojekt (& such things have tendency to go on and
on and on).

References
Alziary, B., Dechamps, J.-P. & Koehl, P.-F. (1997), A p.d.e. approach to Asian options: Analytical
and numerical evidence, Journal of Banking and Finance 21, 613640.
Andersen, L. & Andreasen, J. (2000), Volatility Skews and Extensions of the Libor Market Model,
Applied Mathematical Finance 7, 132.
Andersen, L., Andreasen, J. & Brotherton-Ratcliffe, R. (1998), The passport option, Journal of
Computational Finance 1, 1536.
Andersen, L. & Brotherton-Ratcliffe, R. (1998), The equity option volatility smile: an implicit finite
difference approach, Journal of Computational Finance 1, 538.
Bj
ork, T. (1998), Arbitrage Theory in Continuous Time, Oxford.
Brace, A., Gatarek, D. & Musiela, M. (1997), The market model of interest rate dynamics, Mathematical Finance 7(2), 127154.
Brennan, M. J. & Schwartz, E. S. (1977), Calculation of American Put Options, Journal of Finance
32, 449462.
Carr, P. & Chou, A. (1997), Breaking Barriers, Risk Magazine 10(September).
Carr, P., Ellis, K. & Gupta, V. (1998), Static Hedging of Exotic Options, Journal of Finance
53(3), 11651190.
Chen, S. (1996), Understanding Option-Adjusted Spreads: The Implied Prepayment Hypothesis,
Journal of Portfolio Management 22(Summer), 104113.
Dai, Q. & Singleton, K. J. (2000), Specification Analysis of Affine Term Structure Models, Journal
of Finance 55, 10431978.
3

Derman, E., Ergener, D. & Kani, I. (1995), Static Options Replication, Journal of Derivatives
2, 7895.
Derman, E. & Kani, I. (1994), Riding a smile, RISK 7, 3239.
Duffie, D. (2001), Dynamic Asset Pricing Theory, 3. edn, Princeton University Press.
Duffie, D. & Kan, R. (1996), A Yield-Factor Model of Interest Rates, Mathematical Finance
6(4), 379406.
Dupire, B. (1994), Pricing with a smile, RISK 7, 1820.
Geman, H., El-Karoui, N. & Rochet, J.-C. (1995), Changes of numeraire, changes of probability
measure and option pricing, Journal of Applied Probability 32, 443458.
Heston, S. (1993), A Closed-Form Solution for Options with Stochastics Volatility with Applications
to Bond and Currency Options, Review of Financial Studies 6, 327344.
Hull, J. & White, A. (1987), The pricing of options on assets with stochastic volatilities, Journal
of Finance 42(2), 281300.
Jakobsen, S. (1992), Prepayment and the Valuation of Danish Mortgage-Backed Securities, PhD
thesis, Department of Finance. Aarhus Business School.
Jamshidian, F. (1989), An exact bond option formula, Journal of Finance 44, 205209.
Kemna, A. G. Z. & Vorst, T. C. F. (1990), A Pricing Method for Options Based on Average Asset
Values, Journal of Banking and Finance 14, 113129.
Leisen, D. (1999), The Random-Time Binomial Model, Journal of Economic Dynamics and Control
23, 13551386.
Longstaff, F. A. & Schwartz, E. (2001), Valuing american options by simulation: A simple leastsquares approach, Review of Financial Studies 14, 113147.
Merton, R. (1976), Option pricing when the underlying stock returns are discontinuous, Journal
of Financial Economics 5, 125144.
Miltersen, K., Sandmann, K. & Sondermann, D. (1997), Closed form solutions for term structure
derivatives with log-normal interest rates, Journal of Finance 52, 409430.
Munk, C. (1999), Stochastic Duration and Fast Coupon Bond Option Pricing in Multi-Factor
Models, Review of Derivatives Research 3, 157181.
Richard, S. F. & Roll, R. (1989), Prepayments on fixed-rate mortgage-backed securities, Journal
of Portfolio Management 15(Spring), 7382.
4

Rogers, L. C. G. ans Shi, Z. (1995), The Value of an Asian Option, Journal of Applied Probability
32, 10771088.
Rubinstein, M. & Reiner, E. (1991), Breaking Down the Barriers, Risk Magazine 4(September).
Schroder, M. (1989), Computing the Constant Elasticity of Variance Option Pricing Formula,
Journal of Finance 44(1), 211219.
Seydel, R. (2002), Tools for Computational Finance, Springer.
Stanton, R. (1995), Rational Prepayment and the Valuation of Mortgage-Backed Securities, Review
of Financial Studies 8(3), 677708.
Wilmott, P. (1998), Derivatives, Wiley.