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The title says it all, but let me expand on it. Algorithmic differentiation seems to be a method that allows a program / compiler to determine what the derivative is of a function. I imagine it's a great tool for things like optimization, since many of these algorithms work better if we know the cost function and its derivative.

I know that algorithmic differentiation is not the same as numerical differentiation, since the derivative is not exact. But is it then the same as symbolic differentiation, as implemented in e.g. SymPy, Matlab or Mathematica?

Second, where can it actually be used in quantitative finance? I mentioned optimization, so calibration comes to mind. Greeks are also a natural application, since these are derivatives by definition, but how does that work in the case of Monte Carlo? And are there any other applications?

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  • $\begingroup$ Yes, I believe it is the same as symbolic differentiation, as in Mathematica and Maple, for ex. $\endgroup$ – Alex C Nov 22 '15 at 20:36
  • $\begingroup$ see quant.stackexchange.com/questions/9982/… $\endgroup$ – Mark Joshi Nov 22 '15 at 20:44
  • $\begingroup$ My answer covers the "how does it work" (or more precisely, how can it work) reasonably well, I think, but I omitted the "where can it be applied" part since it was getting long. The short answer to that is, "anywhere you have a function and want its derivative". It's a pretty general and straightforward method, so you shouldn't run into too many hurdles when you use it. $\endgroup$ – Tyler Olsen Nov 24 '15 at 4:04
  • $\begingroup$ As you are asking about applications: Here is a question where my answer suggests to apply automatic differentiation to computing the cumulants of option pricing models with known characteristic functions. The latter are often required for calibration to find integration bounds, ... quant.stackexchange.com/questions/22446. $\endgroup$ – LocalVolatility Feb 16 '17 at 0:28
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Automatic Differentiation (aka AD) is a family of methods that are used to evaluate the derivative of a coded function. These methods are far more accurate than finite differences, since they are theoretically exact in the absence of floating point roundoff error.

AD is, however, subtly different than symbolic differentiation. The key difference here is that computer algebra systems (like Mathematica) will return a function that can be evaluated for a derivative. In many implementations of Automatic differentiation, however, the derivative is computed as a side-effect of evaluating the original function.

There are a number of different ways to implement AD, and they are outlined in a reasonable amount of detail on the wikipedia page.

https://en.wikipedia.org/wiki/Automatic_differentiation

Simple Implementation Method

Perhaps the most straightforward method to implement AD is using "Dual Numbers" and operator overloading. The key idea is to introduce a new type of scalar number, called a Dual Number. The dual number augments the algebra of real numbers by replacing every number $x$ with $x + x' \epsilon$, where $\epsilon$ has the property $\epsilon^2 = 0$.

Using this, you can define the algebra of dual numbers as you might expect:

\begin{align} (u+u'\epsilon) + (v + v'\epsilon) &= (u+v) + (u' + v')\epsilon \\ (u+u'\epsilon) - (v + v'\epsilon) &= (u-v) + (u' - v')\epsilon \\ (u+u'\epsilon) * (v+v'\epsilon) &= (uv) + (uv' + vu')\epsilon \\ (u + u'\epsilon) / (v+v'\epsilon) &= (u/v) + \frac{u'v - uv'}{v^2}\epsilon \end{align}

See the wikipedia page for extensions of this to other functions ($\sin$, $\cos$, $\exp$, ...)

The astute reader will notice that the $\epsilon$ component of the result of any operation between dual numbers implements the chain rule for that operation. Due to this, any sequence of operations (i.e. a coded function) will simultaneously compute the function value and its derivative. The only loss of accuracy that one incurs using this method is floating-point roundoff errors (so you still need to use numerically stable algorithms).

On the software side, the primary burden is the implementation of a Dual Number class and to overload any operators/functions that you want to use. In addition, any functions that you wish to differentiate should be (in C++ parlance) templated on the input type. Eg, rather than:

double f(double x) { ... }

you would write

template<typename T>
T f(T x) {...}

Doing so will allow you to re-use the same code to do normal function calls or to do the AD function calls.

Example Code

Here is a link to my C++ implementation of the method that I use in my finite element library. The code is free to take/use/modify if you'd like. You'll have to strip out the non-standard header and the namespace open/close lines, but it shouldn't have any dependencies to the rest of the library.

https://github.com/tjolsen/YAFEL/blob/master/include/utils/DualNumber.hpp

Final Thoughts

The ideas described here can be generalized to vector-valued inputs/outputs. By doing so, you can compute Jacobians without having to derive what each partial derivative should be. Depending on the dimension of the inputs and outputs, other methods than the Dual Number method described here may be more efficient, so it's worth reading about in more detail.

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  • $\begingroup$ Thanks, that's a great answer. I'm still hoping someone else will provide a list of possible applications, but as you said this is probably just a list of "everywhere you have a derivative". $\endgroup$ – Olaf Nov 24 '15 at 9:48
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    $\begingroup$ The technique is particularly popular in the optimization community, since it is extremely easy to implement Newton-like methods for minimization/root-finding when you have such a tool. Other than that, it is used in nonlinear finite element computations, since computing tangents in this context can often be difficult and bug-prone. These are really just optimization problems that have physical meaning (eg, solving solid mechanics boundary value problems is equivalent to minimizing an energy functional). It seems to see less use in linear problems, since tangent computation is usually simple. $\endgroup$ – Tyler Olsen Nov 24 '15 at 16:04

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