Nine ways to implement the binomial method for option valuation in MATLAB

D.J. Higham

Research output: Contribution to journalArticle

20 Citations (Scopus)

Abstract

In the context ofa real-life application that is of interest to many students, we illustrate how the choices made in translating an algorithm into a high-level computer code can affect the execution time. More precisely, we give nine MATLAB programs that implement the binomial method for valuing a European put option. The first program is a straightforward translation of the pseudocode in Figure 10.4 of The Mathematics of Financial Derivatives, by P. Wilmott, S. Howison, and J. Dewynne, Cambridge University Press, 1995. Four variants of this program are then presented that improve the efficiency by avoiding redundant computation, vectorizing, and accessing subarrays via MATLAB's colon notation. We then consider reformulating the problem via a binomial coefficient expansion. Here, a straightforward implementation is seen to be improved by vectorizing, avoiding overflow and underflow, and exploiting sparsity. Overall, the fastest of the binomial method programs has an execution time that is within a factor 2 of direct evaluation of the Black--Scholes formula. One of the vectorized versions is then used as the basis for a program that values an American put option. The programs show how execution times in MATLAB can be dramatically reduced by using high-level operations on arrays rather than computing with individual components, a principle that applies in many scientific computing environments. The relevant files are downloadable from the World Wide Web.
Original languageEnglish
Pages (from-to)661-677
Number of pages16
JournalSIAM Review
Volume44
Issue number4
DOIs
Publication statusPublished - 2002

Keywords

  • algorithm
  • American option
  • Black--Scholes
  • European option
  • optimization
  • overflow
  • underflow
  • vectorization

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