September 2011 – HPC-QuantLib

The hybrid Heston-Hull-White model is tailor-made to analyse the impact of stochastic interest rates on structured equity notes like e.g. auto-callables.

$\begin{array}{rcl} dS_t &=& (r_t-q_t) S_t dt + \sqrt{v_t} S_t dW_t^S \\ dv_t &=& \kappa_v (\theta_v - v_t) dt + \sigma_v \sqrt{v_t} dW_t^v \\ dr_t & = & \kappa_r(\theta_{r,t}-r_t) dt + \sigma_r dW_t^r \\ \rho_{Sv} dt &=& dW_t^S dW_t^v\\ \rho_{Sr} dt &=& dW_t^S dW_t^r \\ \rho_{vr} dt &=& dW_t^v dW_t^r \end{array}$

Unfortunately a semi-closed solution for european options exists only if at least two correlations are equal to zero which is in general unrealistic. A set of semi-closed approximations for this model can be found here [1]. The QuantLib has a finite difference pricing engine for american, bermudan and european options for the Heston-Hull-White model. This pricing engine supports cash dividends, control variate via the semi-closed Heston Model and pricing different strikes of european options of the same maturity using one backward solver run (especially useful to gain a large speed-up during model calibration.).

The Heston-Hull-White model is a good testbed to test the efficiency of the finite difference schemes based on operator splitting which are implemented in the QuantLib :

Douglas
Craig-Sneyd
Modified Craig-Sneyd
Hundsdorfer-Verwer
Modified Hundsdorfer-Verwer

These operator splitting methods are described here [2]. The testbed contains ten parameter sets of the Heston-Model taken from different publications.

$\begin{array}{|c|c|c|c|c|c|c|c|c|} \hline {\rm Model} & v_0 & \kappa_v & \theta_v & \sigma_v & \rho_{Sv} & r & q & \mbox{Ref} \\ \hline \hline {\rm't\ Hout\ Case\ 1}& 0.04& 1.5& 0.04& 0.3& -0.9& 0.025& 0.0 &[2]\\ {\rm't\ Hout\ Case\ 2} & 0.12& 3.0& 0.12& 0.04& 0.6& 0.01& 0.04 &[2]\\ {\rm't\ Hout\ Case\ 3}& 0.0707&0.6067& 0.0707& 0.2928& -0.7571& 0.03& 0.0 & [2]\\ {\rm't\ Hout\ Case\ 4}& 0.06& 2.5& 0.06& 0.5& -0.1& 0.0507& 0.0469 &[2]\\ {\rm Ikonen\ Toivanen}& 0.0625& 5& 0.16& 0.9& 0.1& 0.1& 0.0 &[3]\\ {\rm Kahl\ J\ddot{a}ckel}& 0.16& 1.0& 0.16& 2.0& -0.8& 0.0& 0.0 &[4]\\ {\rm Equity Case }& 0.07& 2.0& 0.04& 0.55& -0.8& 0.03& 0.035 &\\ {\rm High Correlation}& 0.07& 1.0& 0.04& 0.55& 0.9& 0.02& 0.04& \\ {\rm small\ \sigma_v}& 0.07& 1.0& 0.04& 0.001& -0.75& 0.04& 0.03& \\ \kappa_v=\sigma_v\rho_{Sv}& 0.07& 0.4& 0.04& 0.5& 0.8& 0.03& 0.03 &\\ \hline \end{array}$

The Hull-White parameters are set to $\kappa_r=0.00883$ and $\sigma_r=0.00631$ . The equity interest rate correlation is $\rho_{Sr}=-0.4$ , interest rates and stochastic volatility aren’t correlated $\rho_{vr}=0.$ The benchmark call options have maturity of 5 years, underlying at time $t=0$ is $S_0=100$ and possible strikes are

$K \in \{ 75,85,90,95,100,105,110,115,120,125,130,140,150 \}$ .

The benchmark value is the average relative difference between the reference values and the option prices on the lattice for the different $N_s$ strikes and $N_m$ models.

$\zeta =\frac{1}{N_{s}N_{m}}\sum_{i=1}^{N_{s}N_{m}}\frac{{\rm npv_{ref}^i}-{\rm npv^i}}{K_i}$

The diagram below shows the results of the “Equity Case” for different grid sizes $\{ t, S, v, r\}$ . and with control variate based on the semi–closed Heston Model. Clearly the Douglas scheme is the worst performer, the (modified) Craig-Sneyd and modified Hundsdorfer-Verwer scheme are the winner.

The overall average over the ten models is dominated by the two “pathological” parameter sets “Ikonen-Toivanen” and “Kahl-Jäckel”. Again the Douglas scheme can not compete with the other schemes. The differences between the other schemes are comparable small except for the largest grid where the modified Hundsdorfer-Verwer scheme performs badly.

The relative pricing error with and without control variate is shown in the diagram below for the “Equity Case” Heston model and the modified Craig-Sneyd scheme. On average the usage of the control variate reduces the relative pricing error by a factor of 15.

The source code is available here. It depends on QuantLib 1.1 or higher.If you want to generate the plots you’ll also need R.

[1] L. A. Grzelak, C. W. Oosterleea, Lech A., On the Heston Model with Stochastic Interest Rates.

[2] K.J. in ‘t Hout, S. Foulon, ADI finite difference schemes for option pricing in the Heston model with correlation. Int. J. Numer. Anal. Mod. 7, 303-320 (2010).

[3] S. Ikonen, J. Toivanen, Operator Splitting Methods for American Options with Stochastic Volatility.

[4] C. Kahl, P. Jäckel Not-so-complex logarithms in the Heston model.

The advantages of payoff scripting based on a build-in interpreter or “on-the-fly compiler” instead of implementing the payoffs in C++ are obvious. Faster time-to-market because there is no need to recompile and deploy the C++ pricing library and people without deep C++ knowledge are able to develop and test new structured products. One disadvantage is often the execution speed of the chosen scripting language. Examples of languages I have seen/used for payoff scripting are Python (C++ interface boost::python), Lua, tinycc and CINT. When it comes to execution speed none of these are suited to build high performance solutions, see. e.g. [1]. This is especially true if the Monte-Carlo scenario generator is running on a GPU. The payoff scripting on the CPU can then easily become the bottleneck of your pricing library.

Scala is a modern programming language that integrates object-oriented and functional language features. The Scala compiler generates byte code for the Java VM. Therefore the execution speed of a Scala script is comparable with Java and roughly a factor of two slower than C++ [1].

The Scala compiler itself is a Scala object and can be used at runtime to compile and link new scripts or classes. In addition using JNI it is fairly easy to attach a Java VM to a C++ process and to exchange data between C++ and Scala. Also Scala offers a lot of features to design an “internal”, user-friendly domain specific language (DSL) for payoff scripting.

The code for a small QuantLib/Scala Monte-Carlo simulation in action is available here. It depends on QuantLib 1.0 or higher, a Java 1.6 VM and Scala 2.8/9. Overwrite the PayoffImpl.scala class to implement different payoffs without recompiling the C++ code.

[1] Computer Language Benchmark Game

HPC-QuantLib

Month: September 2011

Finite Difference Schemes for the Heston-Hull-White Model

Using Scala for Payoff Scripting