Imposing no‐arbitrage conditions in implied volatilities using constrained smoothing splines

We apply constrained smoothing B‐splines to the construction of arbitrage‐free implied volatilities and derived measures. The constrained smoothing B‐splines allows the imposition of the constraints of monotonicity and convexity given by the no‐arbitrage conditions in the pricing function. We illustrate the methodology in the construction of implied volatilities and also in the construction of derived measures such as risk‐neutral densities, showing that it can be used as an effective tool for general treatment of option prices. Copyright © 2011 John Wiley & Sons, Ltd.     

On martingale diffusions describing the ‘smile‐effect’ for implied volatilities

This paper discusses diffusion models describing the ‘smile‐effect’ of implied volatilities for option prices partly following the new approach of Bruno Dupire. If one restricts to the time homogeneous case, a careful study of this approach shows that the call option prices considered as a function of the price x of the underlying security, remaining time to maturity T–t and strike price K have necessarily to satisfy a certain functional equation, in order to fit into a coherent model. It is shown that for certain examples of empirically observed option prices which are reported in the literature, this functional equation does not hold. © 2000 John Wiley & Sons, Ltd.     

American put option with regime‐switching volatility (finite time horizon)—Variational inequality approach

We study the fair price of American put option with regime‐switching volatility. Assuming that volatility σ(t) takes two different values σ₁ and σ₂, applying Δ hedging technique we obtain a system of evolutionary variational inequalities, which possesses two free boundaries (optimal exercise boundaries). The following are the main results of this paper.

• 1. Two free boundaries are monotonic and infinitely differentiable.
• 2. The optimal exercise boundary of American put option with regime‐switching volatility in the bearish (or bullish) market is smaller (or higher) than the one of standard American put option. And the price of American put option with regime‐switching volatility in the bearish (or bullish) market is higher (or smaller) than the one of standard American put option.
• 3. The solution of problem (1) is unique.

These results are original in the option pricing with regime‐switching volatility, the proof is technical. Copyright © 2008 John Wiley & Sons, Ltd.     

An Eulerian‐Lagrangian method for option pricing in finance

This article is devoted to the development and application of an Eulerian‐Lagrangian method (ELM) for the solution of the Black‐Scholes partial differential equation for the valuation of European option contracts. This method fully utilizes the transient behavior of the governing equations and generates very accurate option's fair values and their derivatives also known as option Greeks, even if coarse spatial grids and large time steps are used. Numerical experiments on two standard option contracts are presented which show that the ELM method (favorably) compares in terms of accuracy and efficiency to many other well‐perceived methods. © 2006 Wiley Periodicals, Inc. Numer Methods Partial Differential Eq 23: 293–329, 2007     

Finite element method by using quartic B‐splines

In this article, we discuss a kind of finite element method by using quartic B‐splines to solve Dirichlet problem for elliptic equations. Bivariate spline proper subspace of S(Δ) satisfying homogeneous boundary conditions on Type‐2 triangulations and quadratic B‐spline interpolating boundary functions are primarily constructed. Linear and nonlinear elliptic equations are solved by Galerkin quartic B‐spline finite element method. Numerical examples are provided to illustrate the proposed method is flexible. © 2009 Wiley Periodicals, Inc. Numer Methods Partial Differential Eq 27: 818–828, 2011     

Pricing VIX options in a stochastic vol‐of‐vol model

This paper proposes and makes a study of a new model for volatility index option pricing. Factors such as mean‐reversion, jumps, and stochastic volatility are taken into consideration. In particular, the positive volatility skew is addressed by the jump and the stochastic volatility of volatility. Daily calibration is used to check whether the model fits market prices and generates positive volatility skews. Overall, the results show that the mean‐reverting logarithmic jump and stochastic volatility model (called MRLRJSV in the paper) serves as the best model in all the required aspects. Copyright © 2015 John Wiley & Sons, Ltd.     

Option pricing when asset returns jump interruptedly

This paper proposes an extension of Merton's jump‐diffusion model to reflect the time inhomogeneity caused by changes of market states. The benefit is that it simultaneously captures two salient features in asset returns: heavy tailness and volatility clustering. On the basis of an empirical analysis where jumps are found to happen much more frequently in risky periods than in normal periods, we assume that the Poisson process for driving jumps is governed by a two‐state on‐off Markov chain. This makes jumps happen interruptedly and helps to generate different dynamics under these two states. We provide a full analysis for the proposed model and derive the recursive formulas for the conditional state probabilities of the underlying Markov chain. These analytical results lead to an algorithm that can be implemented to determine the prices of European options under normal and risky states. Numerical examples are given to demonstrate how time inhomogeneity influences return distributions, option prices, and volatility smiles. The contrasting patterns seen in different states indicate the insufficiency of using time‐homogeneous models and justify the use of the proposed model. Copyright © 2012 John Wiley & Sons, Ltd.     

Combinatorial problems motivated by comma‐free codes

In the paper some combinatorial problems motivated by comma‐free codes are considered. We describe these problems, give the most significant known results and methods used, present some new results and formulate open problems. © 2004 Wiley Periodicals, Inc.     

Optimal uniform error estimates for moving least‐squares collocation with application to option pricing under jump‐diffusion processes

In this study, we derive optimal uniform error bounds for moving least‐squares (MLS) mesh‐free point collocation (also called finite point method) when applied to solve second‐order elliptic partial integro‐differential equations (PIDEs). In the special case of elliptic partial differential equations (PDEs), we show that our estimate improves the results of Cheng and Cheng (Appl. Numer. Math. 58 (2008), no. 6, 884–898) both in terms of the used error norm (here the uniform norm and there the discrete vector norm) and the obtained order of convergence. We then present optimal convergence rate estimates for second‐order elliptic PIDEs. We proceed by some numerical experiments dealing with elliptic PDEs that confirm the obtained theoretical results. The article concludes with numerical approximation of the linear parabolic PIDE arising from European option pricing problem under Merton's and Kou's jump‐diffusion models. The presented computational results (including the computation of option Greeks) and comparisons with other competing approaches suggest that the MLS collocation scheme is an efficient and reliable numerical method to solve elliptic and parabolic PIDEs arising from applied areas such as financial engineering.     

Three‐dimensional Stokes flow caused by a translating–rotating sphere bisected by a free surface bounding a semi‐infinite micropolar fluid

Explicit velocity and microrotation components and systematic calculation of hydrodynamic quasistatic drag and couple in terms of nondimensional coefficients are presented for the flow problem of an incompressible asymmetrical steady semi‐infinite micropolar fluid arising from the motion of a sphere bisected by a free surface bounding a semi‐infinite micropolar fluid. Two asymmetrical cases are considered for the motion of the sphere: parallel translation to the free surface and rotation about a diameter which is lying in the free surface. The speed of the translational motion and the angular speed for the rotational motion of the sphere are assumed to be small so that the nonlinear terms in the equations of motion can be neglected under the usual Stokesian approximation. A linear slip, Basset‐type, boundary condition has been used. The variation of the resistance coefficients is studied numerically and plotted versus the micropolarity parameter and slip parameter. The two limiting cases of no‐slip and perfect slip are then recovered. Copyright © 2008 John Wiley & Sons, Ltd.     

Teaching complexity theory through student construction of a course wiki: The self‐organization of a scale‐free network

Complex systems are fascinating because emergent phenomena are often unpredictable and appear to arise ex nihilo. The other side of this fascination, however, is a certain difficulty in comprehending complex systems, particularly for students. To help students more fully understand emergence and self‐organization, a course on complexity theory was designed to not only be about these two concepts, but itself embody them. The principal design tool was a course wiki. Here, we quantitatively demonstrate that this course wiki self‐organized into a scale‐free network. This is particularly notable given the small size of the network. We conclude by noting a few qualitative examples of emergence, as well as offering recommendations for the future use of wikis in teaching complexity theory. © 2010 Wiley Periodicals, Inc. Complexity 16: 41–48, 2011     

Assessment and propagation of input uncertainty in tree‐based option pricing models

This paper aims to provide a practical example of assessment and propagation of input uncertainty for option pricing when using tree‐based methods. Input uncertainty is propagated into output uncertainty, reflecting that option prices are as unknown as the inputs they are based on. Option pricing formulas are tools whose validity is conditional not only on how close the model represents reality, but also on the quality of the inputs they use, and those inputs are usually not observable. We show three different approaches to integrating out the model nuisance parameters and show how this translates into model uncertainty in the tree model space for the theoretical option prices. We compare our method with classical calibration‐based results assuming that there is no options market established and no statistical model linking inputs and outputs. These methods can be applied to pricing of instruments for which there is no options market, as well as a methodological tool to account for parameter and model uncertainty in theoretical option pricing. Copyright © 2008 John Wiley & Sons, Ltd.     

A new technique for proving realisability and consistency theorems using finite paraconsistent models of cut‐free logic

A new technique for proving realisability results is presented, and is illustrated in detail for the simple case of arithmetic minus induction. CL is a Gentzen formulation of classical logic. CPQ is CL minus the Cut Rule. The basic proof theory and model theory of CPQ and CL is developed. For the semantics presented CPQ is a paraconsistent logic, i.e. there are non‐trivial CPQ models in which some sentences are both true and false. Two systems of arithmetic minus induction are introduced, CL‐A and CPQ‐A based on CL and CPQ, respectively. The realisability theorem for CPQ‐A is proved: It is shown constructively that to each theorem A of CPQ‐A there is a formula A *, a so‐called “realised disjunctive form of A ”, such that variables bound by essentially existential quantifiers in A * can be written as recursive functions of free variables and variables bound by essentially universal quantifiers. Realisability is then applied to prove the consistency of CL‐A, making use of certain finite non‐trivial inconsistent models of CPQ‐A. (© 2006 WILEY‐VCH Verlag GmbH & Co. KGaA, Weinheim)     

Uncoupling evolutionary groundwater‐surface water flows using the Crank–Nicolson Leapfrog method

Consider an incompressible fluid in a region Ω_f flowing both ways across an interface into a porous media domain Ω_p saturated with the same fluid. The physical processes in each domain have been well studied and are described by the Stokes equations in the fluid region and the Darcy equations in the porous media region. Taking the interfacial conditions into account produces a system with an exactly skew symmetric coupling. Spatial discretization by finite element method and time discretization by Crank–Nicolson LeapFrog give a second‐order partitioned method requiring only one Stokes and one Darcy subphysics and subdomain solver per time step for the fully evolutionary Stokes‐Darcy problem. Analysis of this method leads to a time step condition sufficient for stability and convergence. Numerical tests verify predicted rates of convergence; however, stability tests reveal the problem of growth of numerical noise in unstable modes in some cases. In such instances, the addition of time filters adds stability. © 2012 Wiley Periodicals, Inc. Numer Methods Partial Differential Eq, 2013