NAG Library Routine Document

D03NDF

may be either constant, or functions of time. In the latter case their average instantaneous values over the remaining life of the option should be provided to D03NDF. An auxiliary routine D03NEF is available to compute such averages from values at a set of discrete times. Equation (1) is subject to different boundary conditions depending on the type of option. For a call option the boundary condition is

f (S, t = t_{mat}) = \max (0, S - X)

where

t_{mat}

is the maturity time of the option. For a put option the equation (1) is subject to

f (S, t = t_{mat}) = \max (0, X - S) .

D03NDF also returns values of the Greeks

Θ = \frac{\partial f}{\partial t}, Δ = \frac{\partial f}{\partial x}, Γ = \frac{\partial^{2} f}{\partial x^{2}}, Λ = \frac{\partial f}{\partial σ}, ρ = \frac{\partial f}{\partial r} .

S30ABF also computes the European option price given by the Black–Scholes–Merton formula together with a more comprehensive set of sensitivities (Greeks).

Further details of the analytic solution returned are given in Section 8.1.

4 References

Hull J (1989) Options, Futures and Other Derivative Securities Prentice–Hall

Wilmott P, Howison S and Dewynne J (1995) The Mathematics of Financial Derivatives Cambridge University Press

5 Parameters

1: KOPT – INTEGERInput

On entry: specifies the kind of option to be valued:

$KOPT = 1$: A European call option.
$KOPT = 2$: An American call option.
$KOPT = 3$: A European put option.

Constraints:

$KOPT = 1$ , $2$ or $3$ ;
if $q \neq 0$ , $KOPT \neq 2$ .

2: X – REAL (KIND=nag_wp)Input

On entry: the exercise price

X

Constraint:

X \geq 0.0

3: S – REAL (KIND=nag_wp)Input

On entry: the stock price at which the option value and the Greeks should be evaluated.

Constraint:

S \geq 0.0

4: T – REAL (KIND=nag_wp)Input

On entry: the time at which the option value and the Greeks should be evaluated.

Constraint:

T \geq 0.0

5: TMAT – REAL (KIND=nag_wp)Input

On entry: the maturity time of the option.

Constraint:

TMAT \geq T

6: TDPAR( $3$ ) – LOGICAL arrayInput

On entry: specifies whether or not various parameters are time-dependent. More precisely,

r

is time-dependent if

TDPAR (1) = .TRUE.

and constant otherwise. Similarly,

TDPAR (2)

specifies whether

q

is time-dependent and

TDPAR (3)

specifies whether

σ

is time-dependent.

7: R( $*$ ) – REAL (KIND=nag_wp) arrayInput

Note: the dimension of the array R must be at least

3

TDPAR (1) = .TRUE.

, and at least

1

otherwise.

On entry: if

TDPAR (1) = .FALSE.

then

R (1)

must contain the constant value of

r

. The remaining elements need not be set.

TDPAR (1) = .TRUE.

then

R (1)

must contain the value of

r

at time T and

R (2)

must contain its average instantaneous value over the remaining life of the option:

\hat{r} = \int_{T}^{TMAT} r (ζ) d ζ .

The auxiliary routine D03NEF may be used to construct R from a set of values of

r

at discrete times.

8: Q( $*$ ) – REAL (KIND=nag_wp) arrayInput

Note: the dimension of the array Q must be at least

3

TDPAR (2) = .TRUE.

, and at least

1

otherwise.

On entry: if

TDPAR (2) = .FALSE.

then

Q (1)

must contain the constant value of

q

. The remaining elements need not be set.

TDPAR (2) = .TRUE.

then

Q (1)

must contain the constant value of

q

and

Q (2)

must contain its average instantaneous value over the remaining life of the option:

\hat{q} = \int_{T}^{TMAT} q (ζ) d ζ .

The auxiliary routine D03NEF may be used to construct Q from a set of values of

q

at discrete times.

9: SIGMA( $*$ ) – REAL (KIND=nag_wp) arrayInput

Note: the dimension of the array SIGMA must be at least

3

TDPAR (3) = .TRUE.

, and at least

1

otherwise.

On entry: if

TDPAR (3) = .FALSE.

then

SIGMA (1)

must contain the constant value of

σ

. The remaining elements need not be set.

TDPAR (3) = .TRUE.

then

SIGMA (1)

must contain the value of

σ

at time T,

SIGMA (2)

the average instantaneous value

\hat{σ}

, and

SIGMA (3)

the second-order average

\bar{σ}

, where:

\hat{σ} = \int_{T}^{TMAT} σ (ζ) d ζ,

\bar{σ} = {(\int_{T}^{TMAT} σ^{2} (ζ) d ζ)}^{1 / 2} .

The auxiliary routine D03NEF may be used to compute SIGMA from a set of values at discrete times.

Constraints:

if $TDPAR (3) = .FALSE.$ , $SIGMA (1) > 0.0$ ;
if $TDPAR (3) = .TRUE.$ , $SIGMA (i) > 0.0$ , for $i = 1, 2, 3$ .

10: F – REAL (KIND=nag_wp)Output

On exit: the value

f

of the option at the stock price S and time T.

11: THETA – REAL (KIND=nag_wp)Output

12: DELTA – REAL (KIND=nag_wp)Output

13: GAMMA – REAL (KIND=nag_wp)Output

14: LAMBDA – REAL (KIND=nag_wp)Output

15: RHO – REAL (KIND=nag_wp)Output

On exit: the values of various Greeks at the stock price S and time T, as follows:

\begin{array}{l} THETA = Θ = \frac{\partial f}{\partial t}, & DELTA = Δ = \frac{\partial f}{\partial S}, & GAMMA = Γ = \frac{\partial^{2} f}{\partial S^{2}}, \\ LAMBDA = Λ = \frac{\partial f}{\partial σ}, & RHO = ρ = \frac{\partial f}{\partial r} . \end{array}

16: IFAIL – INTEGERInput/Output

On entry: IFAIL must be set to

0

- 1 ​ or ​ 1

. If you are unfamiliar with this parameter you should refer to Section 3.3 in the Essential Introduction for details.

For environments where it might be inappropriate to halt program execution when an error is detected, the value

- 1 ​ or ​ 1

is recommended. If the output of error messages is undesirable, then the value

1

is recommended. Otherwise, if you are not familiar with this parameter, the recommended value is

0

. When the value $- 1 or 1$ is used it is essential to test the value of IFAIL on exit.

On exit:

IFAIL = 0

unless the routine detects an error or a warning has been flagged (see Section 6).

6 Error Indicators and Warnings

If on entry

IFAIL = 0

- 1

, explanatory error messages are output on the current error message unit (as defined by X04AAF).

Errors or warnings detected by the routine:

$IFAIL = 1$

On entry,	$KOPT < 1$ ,
or	$KOPT > 3$ ,
or	$KOPT = 2$ when $q \neq 0$ ,
or	$X < 0.0$ ,
or	$S < 0.0$ ,
or	$T < 0.0$ ,
or	$TMAT < T$ ,
or	$SIGMA (1) \leq 0.0$ , with $TDPAR (3) = .FALSE.$ ,
or	$SIGMA (i) \leq 0.0$ , with $TDPAR (3) = .TRUE.$ , for some $i = 1$ , $2$ or $3$ .

7 Accuracy

Given accurate values of R, Q and SIGMA no further approximations are made in the evaluation of the Black–Scholes analytic formulae, and the results should therefore be within machine accuracy. The values of R, Q and SIGMA returned from D03NEF are exact for polynomials of degree up to

3

8 Further Comments

8.1 Algorithmic Details

The Black–Scholes analytic formulae are used to compute the solution. For a European call option these are as follows:

f = S e^{- \hat{q} (T - t)} N (d_{1}) - X e^{- \hat{r} (T - t)} N (d_{2})

where

\begin{array}{lcl} d_{1} & = & \frac{\log (S / X) + (\hat{r} - \hat{q} + {\bar{σ}}^{2} / 2) (T - t)}{\bar{σ} \sqrt{T - t}}, \\ d_{2} & = & \frac{\log (S / X) + (\hat{r} - \hat{q} - {\bar{σ}}^{2} / 2) (T - t)}{\bar{σ} \sqrt{T - t}} = d_{1} - \bar{σ} \sqrt{T - t}, \end{array}

N (x)

is the cumulative Normal distribution function and

N^{'} (x)

is its derivative

\begin{array}{lcl} N (x) & = & \frac{1}{\sqrt{2 π}} \int_{- \infty}^{x} e^{- ζ^{2} / 2} d ζ, \\ N^{'} (x) & = & \frac{1}{\sqrt{2 π}} e^{- x^{2} / 2} . \end{array}

The functions

\hat{q}

\hat{r}

\hat{σ}

and

\bar{σ}

are average values of

q

r

and

σ

over the time to maturity:

\begin{array}{lcl} \hat{q} & = & \frac{1}{T - t} \int_{t}^{T} q (ζ) d ζ, \\ \hat{r} & = & \frac{1}{T - t} \int_{t}^{T} r (ζ) d ζ, \\ \hat{σ} & = & \frac{1}{T - t} \int_{t}^{T} σ (ζ) d ζ, \\ \bar{σ} & = & {(\frac{1}{T - t} \int_{t}^{T} σ^{2} (ζ) d ζ)}^{1 / 2} . \end{array}

The Greeks are then calculated as follows:

\begin{array}{lcl} Δ & = & \frac{\partial f}{\partial S} = e^{- \hat{q} (T - t)} N (d_{1}) + \frac{S e^{- \hat{q} (T - t)} N^{'} (d_{1}) - X e^{- \hat{r} (T - t)} N^{'} (d_{2})}{\bar{σ} S \sqrt{T - t}}, \\ Γ & = & \frac{\partial^{2} f}{\partial S^{2}} = \frac{S e^{- \hat{q} (T - t)} N^{'} (d_{1}) + X e^{- \hat{r} (T - t)} N^{'} (d_{2})}{\bar{σ} S^{2} \sqrt{T - t}} + \frac{S e^{- \hat{q} (T - t)} N^{'} (d_{1}) - X e^{- \hat{r} (T - t)} N^{'} (d_{2})}{{\bar{σ}}^{2} S^{2} (T - t)}, \\ Θ & = & \frac{\partial f}{\partial t} = r f + (q - r) S Δ - \frac{σ^{2} S^{2}}{2} Γ, \\ Λ & = & \frac{\partial f}{\partial σ} = (\frac{X d_{1} e^{- \hat{r} (T - t)} N^{'} (d_{2}) - S d_{2} e^{- \hat{q} (T - t)} N^{'} (d_{1})}{{\bar{σ}}^{2}}) \hat{σ}, \\ ρ & = & \frac{\partial f}{\partial r} = X (T - t) e^{- \hat{r} (T - t)} N (d_{2}) + \frac{(S e^{- \hat{q} (T - t)} N^{'} (d_{1}) - X e^{- \hat{r} (T - t)} N^{'} (d_{2})) \sqrt{T - t}}{\bar{σ}} . \end{array}

Note: that

Θ

is obtained from substitution of other Greeks in the Black–Scholes partial differential equation, rather than differentiation of

f

. The values of

q

r

and

σ

appearing in its definition are the instantaneous values, not the averages. Note also that both the first-order average

\hat{σ}

and the second-order average

\bar{σ}

appear in the expression for

Λ

. This results from the fact that

Λ

is the derivative of

f

with respect to

σ

, not

\hat{σ}

For a European put option the equivalent equations are:

\begin{array}{lcl} f & = & X e^{- \hat{r} (T - t)} N (- d_{2}) - S e^{- \hat{q} (T - t)} N (- d_{1}), \\ Δ & = & \frac{\partial f}{\partial S} = - e^{- \hat{q} (T - t)} N (- d_{1}) + \frac{S e^{- \hat{q} (T - t)} N^{'} (- d_{1}) - X e^{- \hat{r} (T - t)} N^{'} (- d_{2})}{\bar{σ} S \sqrt{T - t}}, \\ Γ & = & \frac{\partial^{2} f}{\partial S^{2}} = \frac{X e^{- \hat{r} (T - t)} N^{'} (- d_{2}) + S e^{- \hat{q} (T - t)} N^{'} (- d_{1})}{\bar{σ} S^{2} \sqrt{T - t}} + \frac{X e^{- \hat{r} (T - t)} N^{''} (- d_{2}) - S e^{- \hat{q} (T - t)} N^{''} (- d_{1})}{{\bar{σ}}^{2} S^{2} (T - t)}, \\ Θ & = & \frac{\partial f}{\partial t} = r f + (q - r) S Δ - \frac{σ^{2} S^{2}}{2} Γ, \\ Λ & = & \frac{\partial f}{\partial σ} = (\frac{X d_{1} e^{- \hat{r} (T - t)} N^{'} (- d_{2}) - S d_{2} e^{- \hat{q} (T - t)} N^{'} (- d_{1})}{{\bar{σ}}^{2}}) \hat{σ}, \\ ρ & = & \frac{\partial f}{\partial r} = - X (T - t) e^{- \hat{r} (T - t)} N (- d_{2}) + \frac{(S e^{- \hat{q} (T - t)} N^{'} (- d_{1}) - X e^{- \hat{r} (T - t)} N^{'} (- d_{2})) \sqrt{T - t}}{\hat{σ}} . \end{array}

The analytic solution for an American call option with

q = 0

is identical to that for a European call, since early exercise is never optimal in this case. For all other cases no analytic solution is known.

9 Example

This example solves the Black–Scholes equation for valuation of a

5

-month American call option on a non-dividend-paying stock with an exercise price of $50. The risk-free interest rate is 10% per annum, and the stock volatility is 40% per annum.

The option is valued at a range of times and stock prices.

NAG Library Routine DocumentD03NDF

+− Contents

1 Purpose

2 Specification

3 Description

4 References

5 Parameters

6 Error Indicators and Warnings

7 Accuracy

8 Further Comments

8.1 Algorithmic Details

9 Example

9.1 Program Text

9.2 Program Data

9.3 Program Results

NAG Library Routine Document

D03NDF