Vibrato and automatic differentiation for high order derivatives and sensitivities of financial options.

Summary This paper deals with the computation of second or higher order greeks of financial securities. It combines two methods, Vibrato and automatic differentiation and compares with other methods. We show that this combined technique is faster than standard finite difference, more stable than automatic differentiation of second order derivatives and more general than Malliavin Calculus. We present a generic framework to compute any greeks and present several applications on different types of financial contracts: European and American options, multidimensional Basket Call and stochastic volatility models such as Heston's model. We give also an algorithm to compute derivatives for the Longstaff-Schwartz Monte Carlo method for American options. We also extend automatic differentiation for second order derivatives of options with non-twice differentiable payoff. 1. Introduction. Due to BASEL III regulations, banks are requested to evaluate the sensitivities of their portfolios every day (risk assessment). Some of these portfolios are huge and sensitivities are time consuming to compute accurately. Faced with the problem of building a software for this task and distrusting automatic differentiation for non-differentiable functions, we turned to an idea developed by Mike Giles called Vibrato. Vibrato at core is a differentiation of a combination of likelihood ratio method and pathwise evaluation. In Giles [12], [13], it is shown that the computing time, stability and precision are enhanced compared with numerical differentiation of the full Monte Carlo path. In many cases, double sensitivities, i.e. second derivatives with respect to parameters , are needed (e.g. gamma hedging). Finite difference approximation of sensitivities is a very simple method but its precision is hard to control because it relies on the appropriate choice of the increment. Automatic differentiation of computer programs bypass the difficulty and its computing cost is similar to finite difference, if not cheaper. But in finance the payoff is never twice differentiable and so generalized derivatives have to be used requiring approximations of Dirac functions of which the precision is also doubtful. The purpose of this paper is to investigate the feasibility of Vibrato for second and higher derivatives. We will first compare Vibrato applied twice with the analytic differentiation of Vibrato and show that it is equivalent. as the second is easier we propose the best compromise for second derivatives: Automatic Differentiation of Vibrato. In [8], Capriotti has recently investigated the coupling of different mathematical methods – namely pathwise and likelihood ratio methods – with an Automatic differ.