New control variates for pricing basket options

Abstract

Abstract Accepted by: Giorgio Consigli Accurate pricing of basket options, which are financial derivatives on multiple underlying assets, is a challenging and practically important task for financial institutions. We propose several new control variates for accurate, fast and efficient pricing of basket options. The first approach to deriving new control variates is the use of Hermite polynomial approximation of appropriate function of the underlying asset prices, which leads to a Black–Scholes-like analytic solution. This approach is new in the option pricing context and opens up new possibilities in derivative pricing. Further control variates are analytically derived using Jensen’s inequality in one case, and distributional properties of multivariate Wiener processes in other cases. All the newly proposed control variates are shown to lead to excellent variance reduction in numerical experiments based on realistic data. The proposed methods are novel, computationally simple and have a strong potential to replace more conventional methods, such as the geometric lower bound in simulation-based pricing of basket options and similar products used in financial risk management.