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    Lecture 5 Options

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    Lecture 5 Options

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    Lecture 5 Options

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    of 29

    Deep Learning in Finance

    option pricing

    Damien Challet
    damien.challet@centralesupelec.fr

    4th December 2023


    Hard problems in Finance

    1. Modelling and calibration

    2. Solving high-dimensional equations

    3. Prediction

    4. Portfolio construction
    Options

    Insurance / bet: price/volatility change

    option  right to buy (call) or to sell (put) an asset at price K


    (strike).

     European option: single exercise time T (maturity)


     American option: any time until expiry
     barrier options
     exotic options
    Payoff shape

    Strike K = 100

    from [link]
    Options variables

     asset price pt

     strike price K

     time to maturity T

     interest rate r

    ! option price at time t = 0 ?


    European option price

     Hyp: call option, strike K , time to maturity T

     Option price C = fair price

     Naively,
    C = E [max(pT K ; 0)]
     Interest rate?
    C can be invested in a risk-free asset

    =
    Z1
    C (1 + r )T = E [max(pT K ; 0)]

    P(pT )(pT K )dpT


    K

    ! model of price needed


    Bachelier’s model

     Price evolution

    pt+1 = pt + t
    t  N (0; B2 )
     Normal diffusion
    (pT p0 )2

    P(pT jp0 ) = p
    1 2T  2
    e B
    2 T B

     Additive world
    Black-Scholes model

     Price evolution

    log pt+1 = log pt + t


    t  N (0; BS
    2
    )

     Log-normal diffusion

    P(log pT j log p0 ) = p 1 (log pT log p0 )2


    e 2 T
    2 T 

     N.B.: no jumps, constant volatility


    Fair price in discrete time with hedging

     t 2 f0;    ; T g
     vt : number of shares invested in underlying asset

    Xh i
    C (1 + r )T = E [max(K pT ; 0)]
    t 1
    E (1 + r )T k 1
    vt (pt+1 pt rpt )
    t=0

     vt : hedging (reduce or eliminate risk)


    Optimal hedging

     Capital evolution of option underwriter:

    Xh i
    ∆W = C (1 + r )T [max(K pT ; 0)]
    t 1
    + (1 + r )T k 1
    vt (pt+1 pt rpt )
    t=0

     Residual risk = minfvt g var(∆W )

     Continuous time & Gaussian increments

    ! Black-Scholes miracle:
    zero residual risk with optimal hedging
    Black-Scholes option price

    Continuous-time limit: T = N  , ; 1=N ! 0,


    call price

    CBS (p0 ; K ; T ; r ;  ) = p0 P> [y ] Ke rT


    P> [y+ ]

    p
    1 + erf(x = 2)
    P> (x ) =
    2
    log(p0 =K  e rT )   2 T =2
    y = p
     T
    Price scaling

    CBS (p0 ; K ; T ; r ;  ) = p0 P> [y ] Ke rT


    P> [y+ ]

    p
    1 + erf(x = 2)
    P> (x ) =
    2
    log(p0 =Ke rT )   2 T =2
    y = p
     T
    Ke rT
    Setting k = p0

    CBS (k ; T ; r ;  )
    = P> [y ] kP> [y+ ]
    p0
    Payoff shape

    Strike K = 100

    from [link]
    Black-Scholes option price

    Continuous-time limit: T = N  , ; 1=N ! 0,


    Put price

    PBS (p0 ; K ; T ; r ;  ) = p0 P> [ y ] + Ke rT


    P> [ y+ ]

    p
    1 + erf(x = 2)
    P> (x ) =
    2
    log(p0 =K  e rT )   2 T =2
    y = p
     T
    Parameters of Black and Scholes

     Known: p0 ; K , T

     Possibly known: r

     Optimised: hedging fvt g

     Estimated: 

     Assumed: continuous time, Gaussian returns


    Black-Scholes vs reality: returns

    Heavy-tailed skewed price returns+stochastic volatility

    ! implicit volatility:
    | {z } | {z }
    CBS (p0 ; K ; T ; r ; impl ) = option price(p0 ; K ; T ; r )
    BS world real world

     Heavy tails ! smile


     Skewed returns, leverage effect ! skewed smile
    Non-constant volatility

    ! stochastic volatility model


    ! non-explicit option price formulae (e.g. Heston, etc.)
    N.B.: additional risk: volatility of volatility
    Deep learning and option pricing

    1. Model-driven speed up calibration

    2. Data-driven approach Ito who?

    3. Model + Data improve on 1. and 2.


    1. Deep learning option prices from model

    1. NN fitted to reproduce expensive model output


    1.1 Monte-Carlo
    1.2 Heston
    1.3 Rough Bergomi [link]

    2. Find best parameters of the NN-fitted model


    2.1 with standard optimisation
    2.2 add no-arbitrage conditions
    2.3 NN [link]
    2. Data-driven option price

    1. Fixed parameters (K ; p0 ; r ; T )

    2. Add estimated parameters ;skew, tail exponent

    3. Fit option prices with DL ! option pricer


    3. Deep learning option prices: prices from model and data
    Example: Jang et al. (2020)
    [https://doi.org/10.1016/j.inffus.2020.12.010]
    3. Deep learning option prices from model

    Improvement:
    1. Give what you know as inputs

    2. Learn residuals

    Example: Funahashi (2021) [link]

     Learn C3 Cdata , where C3 = third order approximation of


    CBS
     Smaller training time
     More robust and stable
     Faster calculations
    Solving complex option pricing equations

    Wang et al (2022) [link]

     Physics informed NN (PINNS) (2019) [link] (7200 citations)


    Solving complex option pricing equations

    Physics informed NN (PINNS) (2019) [link] (7200 citations)


    Solving complex option pricing equations
    Wang et al (2022) [link]

    Non-linear BS equation (with transaction costs)

    Two-asset case
    Deep learning: regression + no-arbitrage constraints

    Ackerer, Takasovska and Vatter (2020),


    Deep Smoothing of the Implied Vol Surface [link]

     Implied volatility ansatz (residuals)

     = NN prior
    ! (k ;  ) =  2 

    where prior comes from a model and  : time to maturity


     6 shape and no-arbitrage constraints
    DL: regression + constraints

    C1, C2, C3 are guaranteed by activation function

    Constraints help generalization abilities


    DL: regression + constraints
    Nonarbitrage constraint: put-call parity

     C : call price

     P : put price

     St : spot (current) price

     K : strike price

     T : time to maturity

     r : interest rate
    rT
    C P=S e K

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