Pricing Exotic Options Using Strong Convergence Properties

Abstract

In finance, the strong convergence properties of discretisations of stochastic differential equations (SDEs) are very important for the hedging and valuation of exotic options. In this paper we show how the use of the Milstein scheme can improve the convergence of the multilevel Monte Carlo method, so that the computational cost to achieve an accuracy of O(e) is reduced to O(ϵ−2) for a Lipschitz payoff. The Milstein scheme gives first order strong convergence for all one-dimensional systems (one Wiener process). However, for processes with two or more Wiener processes, such as correlated portfolios and stochastic volatility models, there is no exact solution for the iterated integrals of second order (Lévy area) and the Milstein scheme neglecting the Lévy area gives the same order of convergence as the Euler-Maruyama scheme. The purpose of this paper is to show that if certain conditions are satisfied, we can avoid the calculation of the Lévy area and obtain first convergence order by applying an orthogonal transformation. We demonstrate when the conditions of the two-dimensional problem permit this and give an exact solution for the orthogonal transformation. We present examples of pricing exotic options to demonstrate that the use of both the orthogonal Milstein scheme and the multilevel Monte Carlo give a substantial reduction in the computation cost.