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Swing Options Valuation: a BSDE with Constrained Jumps Approach

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  • Marie Bernhart
  • Huy^en Pham
  • Peter Tankov
  • Xavier Warin

Abstract

We introduce a new probabilistic method for solving a class of impulse control problems based on their representations as Backward Stochastic Differential Equations (BSDEs for short) with constrained jumps. As an example, our method is used for pricing Swing options. We deal with the jump constraint by a penalization procedure and apply a discrete-time backward scheme to the resulting penalized BSDE with jumps. We study the convergence of this numerical method, with respect to the main approximation parameters: the jump intensity $\lambda$, the penalization parameter $p > 0$ and the time step. In particular, we obtain a convergence rate of the error due to penalization of order $(\lambda p)^{\alpha - \frac{1}{2}}, \forall \alpha \in \left(0, \frac{1}{2}\right)$. Combining this approach with Monte Carlo techniques, we then work out the valuation problem of (normalized) Swing options in the Black and Scholes framework. We present numerical tests and compare our results with a classical iteration method.

Suggested Citation

  • Marie Bernhart & Huy^en Pham & Peter Tankov & Xavier Warin, 2011. "Swing Options Valuation: a BSDE with Constrained Jumps Approach," Papers 1101.0975, arXiv.org.
    • Handle: RePEc:arx:papers:1101.0975
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    References listed on IDEAS

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    1. Vathana Ly Vath & Mohamed Mnif & Huyên Pham, 2007. "A model of optimal portfolio selection under liquidity risk and price impact," Finance and Stochastics, Springer, vol. 11(1), pages 51-90, January.
    2. Rene Carmona & Michael Ludkovski, 2008. "Pricing Asset Scheduling Flexibility using Optimal Switching," Applied Mathematical Finance, Taylor & Francis Journals, vol. 15(5-6), pages 405-447.
    3. René Carmona & Nizar Touzi, 2008. "Optimal Multiple Stopping And Valuation Of Swing Options," Mathematical Finance, Wiley Blackwell, vol. 18(2), pages 239-268, April.
    4. Bouchard, Bruno & Touzi, Nizar, 2004. "Discrete-time approximation and Monte-Carlo simulation of backward stochastic differential equations," Stochastic Processes and their Applications, Elsevier, vol. 111(2), pages 175-206, June.
    5. Bally, Vlad & Pagès, Gilles, 2003. "Error analysis of the optimal quantization algorithm for obstacle problems," Stochastic Processes and their Applications, Elsevier, vol. 106(1), pages 1-40, July.
    6. Bouchard, Bruno & Chassagneux, Jean-François, 2008. "Discrete-time approximation for continuously and discretely reflected BSDEs," Stochastic Processes and their Applications, Elsevier, vol. 118(12), pages 2269-2293, December.
    7. Said Hamadène & Monique Jeanblanc, 2007. "On the Starting and Stopping Problem: Application in Reversible Investments," Mathematics of Operations Research, INFORMS, vol. 32(1), pages 182-192, February.
    8. Bouchard, Bruno & Elie, Romuald, 2008. "Discrete-time approximation of decoupled Forward-Backward SDE with jumps," Stochastic Processes and their Applications, Elsevier, vol. 118(1), pages 53-75, January.
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    Cited by:

    1. Tiziano De Angelis & Yerkin Kitapbayev, 2014. "On the optimal exercise boundaries of swing put options," Papers 1407.6860, arXiv.org, revised Jan 2017.

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