Derivatives Analytics with Python & Numpy

Dr. Yves J. Hilpisch

24 June 2011

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CV Yves Hilpisch

19931996 Dipl.-Kfm. (MBA) at Saarland University (Banks and Financial

Markets)

19962000 Dr.rer.pol. (Ph.D.) at Saarland University (Mathematical Finance)

19972004 Management Consultant Financial Services & Insurance Industry

2005present Founder and MD of Visixion GmbH

management and technical consulting work

DEXISIONDerivatives Analytics on Demand (www.dexision.com)
5

2010present Lecturer Saarland University

Course: Numerical Methods for the Market-Based Valuation of Options
Book Project: Market-Based Valuation of Equity DerivativesFrom Theory to
Implementation in Python

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Derivatives Analytics and Python

Data Analysis
Time Series
Cross-Sectional Data

Monte Carlo Simulation

Model Economy
European Options
American Options
Speed-up of 480+ Times

DEXISIONOur Analytics Suite

Capabilities
Technology

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Derivatives Analytics and Python

What is Derivatives Anlytics about?

Derivatives Analytics is concerned with the valuation, hedging and risk management
of derivative financial instruments
In contrast to ordinary financial instruments which may have an intrinsic value (like
the stock of a company), derivative instruments derive their values from other
instruments
Tyical tasks in this context are
simulation
data analysis (historical, current, simulated data)
discounting
arithmetic operations (summing, averaging, etc.)
linear algebra (vector and matrix operations, regression)
solving optimization problems
visualization
...

Python can do all this quite wellbut C, C++, C#, Matlab, VBA, JAVA and other
languages still dominate the financial services industry

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Derivatives Analytics and Python

Why Python for Derivatives Analytics?

Open Source: Python and the majority of available libraries are completely open
source

Syntax: Python programming is easy to learn, the code is quite compact and in
general highly readable (= fast development + easy maintenance)

Multi-Paradigm: Python is as good at functional programming as well as at object

oriented programming

Interpreted: Python is an interpreted language which makes rapid prototyping and

development in general a bit more convenient

Libraries: nowadays, there is a wealth of powerful libraries available and the supply
grows steadily; there is hardly a problem which cannot be easily attacked with an
existing library

Speed: a common prejudice with regard to interpreted languagescompared to

compiled ones like C++ or Cis the slow speed of code execution; however, financial
applications are more or less all about matrix/array manipulations and other
operations which can be done at the speed of C code with the essential library Numpy

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Derivatives Analytics and Python

What does the financial market say about Python?

in the London area (mainly financial services) the number of Python developer
contract offerings evolved as follows (respectively for the three months period ending
on 22 April)
142 in year 2009
245 in year 2010
644 in year 2011

these figures imply a more than fourfold demand for the Python skill in 2011 as
compared to 2009
over the same period, the average daily rate for contract work increased from 400
GBP to 475 GBP1
obviously, Python is catching up at a rapid pace in the financial services industry ...

Source: all figures from www.itjobswatch.co.uk/contracts/london/python.do on 24 April 2011.

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Data Analysis

In Derivatives Analytics you have to analyze different types of data

Fundamental types of data to be analyzed

time series
cross sections

Python libraries suited to analyze and visualize such data

xlrd (www.python-excel.org): reading data from Excel files
Numpy (numpy.scipy.org): array manipulations of any kind
Pandas (code.google.com/p/pandas): time series analysis, cross-sectional data
analysis2
matplotlib (matplotlib.sourceforge.net): 2d and 3d plotting

Notably, this library was developed by a hedge fund.

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Data Analysis

Time Series

DAX time seriesindex level and daily log returns3

8000
DAX Daily Quotes

7000
6000
5000
4000
3000
2000
1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

DAX Daily Log Returns

0.10

0.05
0.00
0.05

Source: http://finance.yahoo.com, 29 Apr 2011

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Data Analysis

Time Series

Reading data from Excel file ...

from
from
from
from
from

xlrd import open_workbook

pandas import *
datetime import *
matplotlib . pyplot import *
numpy import *

# DAX Open Workbook , Read

xls = open_workbook ( ' D A X _ D a i l y _ 1 9 9 0 _ 2 0 1 1 . xls ')
for s in xls . sheets ():
datesDAX = []; quoteDAX = []
for row in range ( s . nrows -1 ,0 , - 1 ):
year = int ( s . cell ( row , 0 ). value )
month = int ( s . cell ( row , 1 ). value )
day
= int ( s . cell ( row , 2 ). value )
datesDAX . append ( date ( year , month , day ))
quoteDAX . append ( float ( s . cell ( row , 8 ). value ))
print

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Data Analysis

Time Series

... and plotting it with Pandas and matplotlib

DAXq = Series ( quoteDAX , index = datesDAX )

DAXr = Series ( log ( DAXq / DAXq . shift ( 1 )) , index = datesDAX )
DAXr = where ( isnull ( DAXr ) , 0 .0 , DAXr )
# Data Frames for Quotes and Returns
data = { ' QUO ': DAXq , ' RET ': DAXr , ' RVO ': rv }
DAX = DataFrame ( data , index = DAXq . index )
# Graphical Output
figure ()
subplot ( 211 )
plot ( DAX . index , DAX [ ' QUO ' ])
ylabel ( ' DAX Daily Quotes ')
grid ( True ); axis ( ' tight ')
subplot ( 212 )
plot ( DAX . index , DAX [ ' RET ' ])
ylabel ( ' DAX Daily Log Returns ')
grid ( True ); axis ( ' tight ')

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Data Analysis

Time Series

Corr (252d Mov)

Vola (252d Mov)

Return (252d Mov)

DAX time series252 moving mean return, volatility and correlation

between both4

0.8
0.6
0.4
0.2
0.0
0.2
0.4
0.6
0.8
1.01992
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.101992
1.0

1996

1998

2000

2002

2004

2006

2008

2010

1994

1996

1998

2000

2002

2004

2006

2008

2010

1994

1996

1998

2000

2002

2004

2006

2008

2010

0.5
0.0
0.5
1.01992

1994

Source: http://finance.yahoo.com, 29 Apr 2011

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Data Analysis

Time Series

Pandas provides a number of really convenient functions

# mean return , volatility and correlation ( 252 days moving = 1 year )

figure ()
subplot ( 311 )
mr252 = Series ( rolling_mean ( DAX [ ' RET '] , 252 )* 252 , index = DAX . index )
mr252 . plot (); grid ( True ); ylabel ( ' Return ( 252d Mov ) ')
x , y = REG ( mr252 , 0 ); plot (x , y )
subplot ( 312 )
vo252 = Series ( rolling_std ( DAX [ ' RET '] , 252 )* sqrt ( 252 ) , index = DAX . index )
vo252 . plot (); grid ( True ); ylabel ( ' Vola ( 252d Mov ) ')
x , y = REG ( vo252 , 0 ); plot (x , y ); vx = axis ()
subplot ( 313 )
co252 = Series ( rolling_corr ( mr252 , vo252 , 252 ) , index = DAX . index )
co252 . plot (); grid ( True ); ylabel ( ' Corr ( 252d Mov ) ')
x , y = REG ( co252 , 0 ); plot (x , y ); cx = axis ()
axis ([ vx [ 0 ] , vx [ 1 ] , cx [ 2 ] , cx [ 3 ]])

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Data Analysis

Cross-Sectional Data

DAX cross-sectional dataimplied volatility surface5

21
20

Implied Volatility

19
18
17
16
15
14
13
12
7000

7200

7400

Strike

7600

7800

8000

maturities: 21 (red dots), 49 (green crosses), 140 (blue triangles),

231 (yellow stones) and 322 days (purple hectagons)
5

Source: http://www.eurexchange.com, 29 Apr 2011

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Monte Carlo Simulation

Model Economy

Model economyBlack-Scholes-Merton continuous time

economy with final date T, 0 < T <

uncertainty is represented by a filtered probability space {, F, F, P }
for 0 t T the risk-neutral index dynamics are given by the SDE
dSt
= rdt + dZt
St

(1)

St index level at date t, r constant risk-less short rate, constant volatility of the
index and Zt standard Brownian motion
the process S generates the filtration F, i.e. Ft F(S0st )
a risk-less zero-coupon bond satisfies the DE
dBt
= rdt
Bt

(2)

the time t value of a zero-coupon bond paying one unit of currency at T with
0 t < T is Bt (T ) = er(T t)

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Monte Carlo Simulation

Model Economy

Model economyBlack-Scholes-Merton discrete time

to simulate the financial model, i.e. to generate numerical values for St , the SDE
(1) has to be discretized
to this end, divide the given time interval [0, T ] in equidistant sub-intervals t such
that now t {0, t, 2t, ..., T }, i.e. there are M + 1 points in time with M T /t
a discrete version of the continuous time market model (1)(2) is
St
Stt
Bt
Btt

r 2

ert

t+

tzt

(3)
(4)

for t {t, ..., T } and standard normally distributed zt

this scheme is an Euler discretization which is known to be exact for the geometric
Brownian motion (1)

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Monte Carlo Simulation

European Options

Option valuation by simulationEuropean options

a European put option on the index S pays at maturity T

h(ST ) max[K ST , 0]
for a fixed strike price K
to value such an option, simulate I paths of St such that you get I values
ST,i , i {1, ..., I}
the Monte Carlo estimator for the put option value then is
V0 = erT

Y. Hilpisch (Visixion GmbH)

1
I

h(ST,i )
i=1

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Monte Carlo Simulation

European Options

Simulating the index level for European option valuation6

Average Drift
50

40

30

Jan 1, 2011

Jun 15, 2011

Dec 1, 2011

20 simulated index level paths; thick blue line = average drift

Source: analytics.dexision.com
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Monte Carlo Simulation

European Options

Numpy offers all you need for an efficient implementation (I)

#
# Valuation of European Put Option
# by Monte Carlo Simulation
#
from numpy import *
from numpy . random import standard_normal , seed
from time import time
t0 = time ()
# # Parameters -- American Put Option
S0 = 36 .
# initial stock level
K = 40 .
# strike price
T = 1.0
# time - to - maturity
vol = 0 . 2
# volatility
r = 0 . 06
# short rate
# # Simulation Parameters
seed ( 150000 )
# seed for Python RNG
M = 50
# time steps
I = 50000
# simulation paths
dt = T / M
# length of time interval
df = exp ( - r * dt ) # discount factor per time interval

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Monte Carlo Simulation

European Options

Numpy offers all you need for an efficient implementation (II)

# # Index Level Path Generation

S = zeros (( M +1 , I ) , 'd ')
# index value matrix
S [0 ,:]= S0
# initial values
for t in range (1 , M +1 , 1 ):
# stock price paths
ran = s ta ndard_normal ( I )
# pseudo - random numbers
S [t ,:]= S [t -1 ,:]* exp (( r - vol ** 2 / 2 )* dt + vol * ran * sqrt ( dt ))
# # Valuation
h = maximum (K - S [ - 1 ] , 0 )
V0 = exp ( - r * T )* sum ( h )/ I

# inner values at maturity

# MCS estimator

# # Output
print " Time elapsed in Seconds
% 8 . 3f " %( time () - t0 )
print " - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - "
print " European Put Option Value % 8 . 3f " % V0
print " - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - "

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Monte Carlo Simulation

American Options

American optionssolving optimal stopping problems (I)

to value American options by Monte Carlo simulation, a discrete optimal stopping

problem has to be solved:
V0 =

sup
{0,t,2t,...,T }

EQ
0 (B0 ( )h (S ))

(5)

it is well-known that the value of the American option at date t is then given by
(6)

Vt (s) = max[ht (s), Ct (s)]

i.e. the maximum of the payoff ht (s) of immediate exercise and the expected payoff
Ct (s) of not exercising; this quantity is given as
rt
Vt+t (St+t )|St = s)
Ct (s) = EQ
t (e

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Monte Carlo Simulation

American Options

American optionssolving optimal stopping problems (II)

problem: given a date t and a path i, you do not know the expected value in
(7)you only know the single simulated continuation value Yt,i
solution of Longstaff and Schwartz (2001): estimate the continuation values
Ct,i by ordinary least-squares regressiongiven the I simulated index levels St,i and
continuation values Yt,i (use cross section of simulated data at date t)
their algorithm is called Least Squares Monte Carlo (LSM)

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Monte Carlo Simulation

American Options

The LSM algorithmregression for American put option7

Source: analytics.dexision.com
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Monte Carlo Simulation

American Options

The LSM algorithmbackwards exercise/valuation8

Source: analytics.dexision.com
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Monte Carlo Simulation

American Options

Again, the Python/Numpy implementation is straightforward (I)

#
# Valuation of American Put Option
# with Least - Squares Monte Carlo
#
from numpy import *
from numpy . random import standard_normal , seed
from matplotlib . pyplot import *
from time import time
t0 = time ()
# # Simulation Parameters
seed ( 150000 )
# seed for Python RNG
M = 50
# time steps
I = 4 * 4096
# paths for valuation
reg = 9
# no of basis functions
AP = True
# antithetic paths
MM = True
# moment matching of RN
# # Parameters -r = 0 . 06
vol = 0 . 2
S0 = 36 .
T = 1.0
V0_right = 4 . 48637
dt = T / M
df = exp ( - r * dt )

American Put Option

# short rate
# volatility
# initial stock level
# time - to - maturity
# American Put Option ( 500 steps bin . model )
# length of time interval
# discount factor per time interval

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Monte Carlo Simulation

American Options

Again, the Python/Numpy implementation is straightforward (II)

# # Function Definitions
def RNG ( I ):
if AP == True :
ran = standard_no rm a l ( I / 2 )
ran = concatenate (( ran , - ran ))
else :
ran = standard_no rm a l ( I )
if MM == True :
ran = ran - mean ( ran )
ran = ran / std ( ran )
return ran
def GenS ( I ):
S = zeros (( M +1 , I ) , 'd ')
# index level matrix
S [0 ,:]= S0
# initial values
for t in range (1 , M +1 , 1 ):
# index level paths
ran = RNG ( I )
S [t ,:]= S [t -1 ,:]* exp (( r - vol ** 2 / 2 )* dt + vol * ran * sqrt ( dt ))
return S
def IV ( S ):
return maximum ( 40 . -S , 0 )

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Monte Carlo Simulation

American Options

Again, the Python/Numpy implementation is straightforward (III)

# # Valuation by LSM
S = GenS ( I )
# generate stock price
h = IV ( S )
# inner value matrix
V = IV ( S )
# value matrix
for t in range (M -1 , -1 , - 1 ):
rg = polyfit ( S [t ,:] , V [ t +1 ,:]* df , reg )
#
C = polyval ( rg , S [t ,:])
#
V [t ,:]= where ( h [t ,:] > C , h [t ,:] , V [ t +1 ,:]* df ) #
V0 = sum ( V [0 ,:])/ I # LSM estimator

paths

regression at time t
continuation values
exercise decision

# # Output
print " Time elapsed in Seconds
% 8 . 3f " %( time () - t0 )
print " - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - "
print " Right Value
% 8 . 3f " % V0_right
print " - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - "
print " LSM Value for Am . Option % 8 . 3f " % V0
print " Absolute Error
% 8 . 3f " %( V0 - V0_right )
print " Relative Error in Percent % 8 . 3f " %(( V0 - V0_right )/ V0_right * 100 )
print " - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - "

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Monte Carlo Simulation

Speed-up of 480+ Times

The Challengedozens of minutes in Matlab

realistic market models generally include multiple sources of randomness which are
possibly correlated
the simulation of such complex models in combination with Least Squares Monte
Carlo is computationally demanding and time consuming
in their research paper, Medvedev and Scaillet (2009) analyze the valuation of
American put options in the presence of stochastic volatility and stochastic short
rates
Medvedev and Scaillet (2009) write on page 16:
To give an idea of the computational advantage of our method, a Matlab code
implementing the algorithm of Longstaff and Schwartz (2001) takes dozens of
minutes to compute a single option price while our approximation takes roughly a
tenth of a second.

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Monte Carlo Simulation

Speed-up of 480+ Times

The Resultsonly seconds in Python

Python is well-suited to implement efficent, i.e. fast and accurate, numerical

valuation algorithms
MCS/LSM with 25 steps/35,000 paths:
180 megabytes of data crunched in 1.5 seconds
MCS/LSM with 50 steps/100,000 paths:
980 megabytes of data crunched in 8.5 seconds

reported times are from my 3 years old notebook ...

the speed-up compared to the times reported in Medvedev and Scaillet (2009) is
480+ times (1.5 seconds vs. 720+ seconds)
to reach this speed-up, our algorithm mainly uses variance reductions techniques
(like moment matching and control variates) which allows to reduce the number of
time steps and paths significantly

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Monte Carlo Simulation

Speed-up of 480+ Times

Results from 3 simulation runs for the 36 American put options of

Medvedev and Scaillet (2009)
---------------------------------------------------Start Calculations
2011-06-22 13:43:02.163000
---------------------------------------------------Name of Simulation
Base_3_25_35_TTF_2.5_1.5
Seed Value for RNG
150000
Number of Runs
3
Time Steps
25
Paths
35000
Control Variates
True
Moment Matching
True
Antithetic Paths
False
Option Prices
108
Absolute Tolerance
0.0250
Relative Tolerance
0.0150
Errors
0
Error Ratio
0.0000
Aver Val Error
-0.0059
Aver Abs Val Error
0.0154
Time in Seconds
135.7890
Time in Minutes
2.2631
Time per Option
1.2573
---------------------------------------------------End
Calculations
2011-06-22 13:45:17.952000
----------------------------------------------------

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DEXISIONOur Analytics Suite

Capabilities

DEXISION can handle a number of financial derivatives ranging from plain

vanilla to complex and exotic

Example products:
plain vanilla options
American options
Asian options
options on baskets
certificates (bonus, express, etc.)
swaps, swaptions
real options
portfolios of options
life insurance contracts

Example underlyings:
indices
stocks
bonds
interest rates
currencies
commodities

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DEXISIONOur Analytics Suite

Capabilities

DEXISION can be beneficially applied in a number of areas

financial research: researchers, lecturers and students in (mathematical) finance find

in DEXISION an easy-to-learn tool to model, value and analyze financial derivatives
financial engineering: financial engineers and risk managers in investment banks,
hedge funds, etc. can use DEXISION to quickly model and value diverse financial
products, to cross-check valuations and to assess risks of complex derivatives
portfolios
actuarial calculations: those responsible for the design, valuation and risk
management of market-oriented insurance products can engineer, value and test new
and existing products easily
financial reporting: IFRS and other reporting standards require the use of formal
(option) pricing models when there are no market prices; DEXISION considerably
simplifies the modelling, valuation and risk assessment for illiquid, complex,
non-traded financial instruments and embedded options
real options valuation: DEXISION offers unique capabilities to account for the
specifics of real options (as compared to financial options)

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DEXISIONOur Analytics Suite

Technology

DEXISION is based on a Python-LAMP environment and makes heavy use of

Numpy

Suse Linux 11.1 as 64 bit operating system

Apache 2 as Web server
MySQL 5.0.67 as relational database
Python 2.6 as core language (integrated via mod_python in Apache)
Numpy 1.3.0 as fast linear algebra library
Dojo 1.0 as JavaScript framework for the GUI
SVG for all custom graphics
MoinMoin Wiki (Python powered) for Web documentation

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DEXISIONOur Analytics Suite

Technology

Our aim is to make DEXISION the Google of Derivatives Analytics

recently, Visixion added Web services to DEXISIONs functionalities which allow to

integrate it into any environment
once a structure is modeled in DEXISION, updates of valuations can be received in
real-time via these Web services (with data delivered e.g. in XML format)
during the Web service call, data/variables can also be provided
a call to value an American put option on the DAX index could look like:
https://company.dexision.com/DEXISIONeval.py?company=X&user=Y&pwd=
Z&paths=50000&steps=150&portfolio=DAX/DAX_Am_Put_Dec_2011&DAX_
current=7200&DAX_vola=0.175&rate=0.03&strike=6800

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DEXISIONOur Analytics Suite

Technology

Contact

Dr. Yves J. Hilpisch

Visixion GmbH
Rathausstrasse 75-79
66333 Voelklingen
Germany
www.visixion.com Derivatives Analytics and Python Programming
www.dexision.com Derivatives Analytics On Demand
E [email protected]
T/F +49 3212 1129194

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