Functional Itô calculus, path-dependence and the computation of Greeks

Samy Jazaerli and Yuri F. Saporito

Stochastic Processes and their Applications, 2017, vol. 127, issue 12, 3997-4028

Abstract: Dupire’s functional Itô calculus provides an alternative approach to the classical Malliavin calculus for the computation of sensitivities, also called Greeks, of path-dependent derivatives prices. In this paper, we introduce a measure of path-dependence of functionals within the functional Itô calculus framework. Namely, we consider the Lie bracket of the space and time functional derivatives, which we use to classify functionals accordingly to their degree of path-dependence. We then revisit the problem of efficient numerical computation of Greeks for path-dependent derivatives using integration by parts techniques. Special attention is paid to path-dependent functionals with zero Lie bracket, called locally weakly path-dependent functionals in our classification. Hence, we derive the weighted-expectation formulas for their Greeks. In the more general case of fully path-dependent functionals, we show that, equipped with the functional Itô calculus, we are able to analyze the effect of the Lie bracket on the computation of Greeks. Moreover, we are also able to consider the more general dynamics of path-dependent volatility. These were not achieved using Malliavin calculus.

Keywords: Functional Itô calculus; Path-dependence; Greeks; Monte Carlo methods (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (3)

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DOI: 10.1016/j.spa.2017.03.015

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