Path-dependent option pricing with two-dimensional PDE using MPDATA

TL;DR

This paper presents a robust, high-order finite-difference PDE method using MPDATA for pricing path-dependent Asian options, validated against Monte Carlo and analytical solutions, emphasizing stability and efficiency in two-dimensional problems.

Contribution

The paper introduces a novel application of MPDATA to two-dimensional Asian option pricing, transforming the Black-Merton-Scholes PDE into a transport problem and demonstrating its robustness and accuracy.

Findings

MPDATA improves solution accuracy over first-order schemes.

The valuation scheme is conservative, non-oscillatory, and positive-definite.

Validation against Monte Carlo and analytical solutions confirms effectiveness.

Abstract

In this paper, we discuss a simple yet robust PDE method for evaluating path-dependent Asian-style options using the non-oscillatory forward-in-time second-order MPDATA finite-difference scheme. The valuation methodology involves casting the Black-Merton-Scholes equation as a transport problem by first transforming it into a homogeneous advection-diffusion PDE via variable substitution, and then expressing the diffusion term as an advective flux using the pseudo-velocity technique. As a result, all terms of the Black-Merton-Sholes equation are consistently represented using a single high-order numerical scheme for the advection operator. We detail the additional steps required to solve the two-dimensional valuation problem compared to MPDATA valuations of vanilla instruments documented in a prior study. Using test cases employing fixed-strike instruments, we validate the solutions against Monte Carlo valuations, as well as against an approximate analytical solution in which geometric instead of arithmetic averaging is used. The analysis highlights the critical importance of the MPDATA corrective steps that improve the solution over the underlying first-order "upwind" step. The introduced valuation scheme is robust: conservative, non-oscillatory, and positive-definite; yet lucid: explicit in time, engendering intuitive stability-condition interpretation and inflow/outflow boundary-condition heuristics. MPDATA is particularly well suited for two-dimensional problems as it is not a dimensionally split scheme. The documented valuation workflow also constitutes a useful two-dimensional case for testing advection schemes featuring both Monte Carlo solutions and analytic bounds. An implementation of the introduced valuation workflow, based on the PyMPDATA package and the Numba Just-In-Time compiler for Python, is provided as free and open source software.