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A monotone piecewise constant control integration approach for the two-factor uncertain volatility model

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  • Duy-Minh Dang
  • Hao Zhou

Abstract

Prices of option contracts on two assets within uncertain volatility models for worst and best-case scenarios satisfy a two-dimensional Hamilton-Jacobi-Bellman (HJB) partial differential equation (PDE) with cross derivatives terms. Traditional methods mainly involve finite differences and policy iteration. This "discretize, then optimize" paradigm requires complex rotations of computational stencils for monotonicity. This paper presents a novel and more streamlined "decompose and integrate, then optimize" approach to tackle the aforementioned HJB PDE. Within each timestep, our strategy employs a piecewise constant control, breaking down the HJB PDE into independent linear two-dimensional PDEs. Using known closed-form expressions for the Fourier transforms of the Green's functions associated with these PDEs, we determine an explicit formula for these functions. Since the Green's functions are non-negative, the solutions to the PDEs, cast as two-dimensional convolution integrals, can be conveniently approximated using a monotone integration method. Such integration methods, including a composite quadrature rule, are generally available in popular programming languages. To further enhance efficiency, we propose an implementation of this monotone integration scheme via Fast Fourier Transforms, exploiting the Toeplitz matrix structure. Optimal control is subsequently obtained by efficiently synthesizing the solutions of the individual PDEs. The proposed monotone piecewise constant control method is demonstrated to be both $\ell_{\infty} $-stable and consistent in the viscosity sense, ensuring its convergence to the viscosity solution of the HJB equation. Numerical results show remarkable agreement with benchmark solutions obtained by unconditionally monotone finite differences, tree methods, and Monte Carlo simulation, underscoring the robustness and effectiveness of our method.

Suggested Citation

  • Duy-Minh Dang & Hao Zhou, 2024. "A monotone piecewise constant control integration approach for the two-factor uncertain volatility model," Papers 2402.06840, arXiv.org, revised Feb 2024.
  • Handle: RePEc:arx:papers:2402.06840
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    References listed on IDEAS

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    1. Adam Smith, 2002. "American options under uncertain volatility," Applied Mathematical Finance, Taylor & Francis Journals, vol. 9(2), pages 123-141.
    2. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," The Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    3. Dokuchaev, Nikolai G. & Savkin, Andrey V., 1998. "The pricing of options in a financial market model with transaction costs and uncertain volatility," Journal of Multinational Financial Management, Elsevier, vol. 8(2-3), pages 353-364, September.
    4. Bartosz Jaroszkowski & Max Jensen, 2022. "Valuation of European Options Under an Uncertain Market Price of Volatility Risk," Applied Mathematical Finance, Taylor & Francis Journals, vol. 29(3), pages 213-226, May.
    5. T. J. Lyons, 1995. "Uncertain volatility and the risk-free synthesis of derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 2(2), pages 117-133.
    6. Marjon Ruijter & Kees Oosterlee, 2012. "Two-dimensional Fourier cosine series expansion method for pricing financial options," CPB Discussion Paper 225, CPB Netherlands Bureau for Economic Policy Analysis.
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