Applying a Power Penalty Method to Numerically Pricing American Bond Options

In this paper, we aim to develop a numerical scheme to price American options on a zero-coupon bond based on a power penalty approach. This pricing problem is formulated as a variational inequality problem (VI) or a complementarity problem (CP). We apply a fitted finite volume discretization in space along with an implicit scheme in time, to the variational inequality problem, and obtain a discretized linear complementarity problem (LCP). We then develop a power penalty approach to solve the LCP by solving a system of nonlinear equations. The unique solvability and convergence of the penalized problem are established. Finally, we carry out numerical experiments to examine the convergence of the power penalty method and to testify the efficiency and effectiveness of our numerical scheme.     

A fast high-order finite difference algorithm for pricing American options

We describe an improvement of Han and Wu’s algorithm [H. Han, X.Wu, A fast numerical method for the Black–Scholes equation of American options, SIAM J. Numer. Anal. 41 (6) (2003) 2081–2095] for American options. A high-order optimal compact scheme is used to discretise the transformed Black–Scholes PDE under a singularity separating framework. A more accurate free boundary location based on the smooth pasting condition and the use of a non-uniform grid with a modified tridiagonal solver lead to an efficient implementation of the free boundary value problem. Extensive numerical experiments show that the new finite difference algorithm converges rapidly and numerical solutions with good accuracy are obtained. Comparisons with some recently proposed methods for the American options problem are carried out to show the advantage of our numerical method.     

An efficient ETD method for pricing American options under stochastic volatility with nonsmooth payoffs

Based on Cox and Matthews Exponential Time Differencing (ETD) approach, a fourth–order strongly–stable method having real distinct poles is developed and applied to solve American options under stochastic volatility with nonsmooth payoffs. A computationally efficient version of the method is constructed using partial fraction splitting technique. This approach requires to solve several backward Euler‐type linear systems at each time step. Numerical experiments are presented to demonstrate the computational efficiency, accuracy, and reliability of the method. © 2013 Wiley Periodicals, Inc. Numer Methods Partial Differential Eq, 2013     

Efficient L-stable method for parabolic problems with application to pricing American options under stochastic volatility

Efficient L-stable numerical method for semilinear parabolic problems with nonsmooth initial data is proposed and implemented to solve Heston’s stochastic volatility model based PDE for pricing American options under stochastic volatility. The proposed new method is also used to solve two asset American options pricing problem. Cox and Matthews [S.M. Cox, P.C. Matthews, Exponential time differencing for stiff systems, Journal of Computational Physics 176 (2002) 430-455] developed a class of exponential time differencing Runge-Kutta schemes (ETDRK) for nonlinear parabolic problems. Kassam and Trefethen [A.K. Kassam, L.N. Trefethen, Fourth-order time stepping for stiff PDEs, SIAM Journal on Scientific Computing 26 (4) (2005) 1214-1233] showed that while computing certain functions involved in the Cox-Matthews schemes, severe cancelation errors can occur which affect the accuracy and stability of the schemes. Kassam and Trefethen proposed complex contour integration technique to implement these schemes in a way that avoids these cancelation errors. But this approach creates new difficulties in choosing and evaluating the contour integrals for larger problems. We modify the ETDRK schemes using positivity preserving Padé approximations of the matrix exponential functions and construct computationally efficient parallel version using splitting technique. As a result of this approach it is required only to solve several backward Euler linear problems in serial or parallel.     

A new predictor-corrector scheme for valuing American puts

In this paper, we present a new numerical scheme, based on the finite difference method, to solve American put option pricing problems. Upon applying a Landau transform or the so-called front-fixing technique [19] to the Black-Scholes partial differential equation, a predictor-corrector finite difference scheme is proposed to numerically solve the nonlinear differential system. Through the comparison with Zhu’s analytical solution [35], we shall demonstrate that the numerical results obtained from the new scheme converge well to the exact optimal exercise boundary and option values. The results of our numerical examples suggest that this approach can be used as an accurate and efficient method even for pricing other types of financial derivative with American-style exercise.     

An almost L‐stable BDF‐type method for the numerical solution of stiff ODEs arising from the method of lines

A new BDF‐type scheme is proposed for the numerical integration of the system of ordinary differential equations that arises in the Method of Lines solution of time‐dependent partial differential equations. This system is usually stiff, so it is desirable for the numerical method to solve it to have good properties concerning stability. The method proposed in this article is almost L‐stable and of algebraic order three. Numerical experiments illustrate the performance of the new method on different stiff systems of ODEs after discretizing in the space variable some PDE problems. © 2007 Wiley Periodicals, Inc. Numer Methods Partial Differential Eq, 2007     

Exponential Time Differencing-Padé Finite Element Method for Nonlinear Convection-Diffusion-Reaction Equations with Time Constant Delay

In this paper, ETD3-Padé and ETD4-Padé Galerkin finite element methods are proposed and analyzed for nonlinear delayed convection-diffusion-reaction equations with Dirichlet boundary conditions. An ETD-based RK is used for time integration of the corresponding equation. To overcome a well-known difficulty of numerical instability associated with the computation of the exponential operator, the Padé approach is used for such an exponential operator approximation, which in turn leads to the corresponding ETD-Padé schemes. An unconditional $L^2$ numerical stability is proved for the proposed numerical schemes, under a global Lipshitz continuity assumption. In addition, optimal rate error estimates are provided, which gives the convergence order of $O(k^{3}+h^{r})$ (ETD3-Padé) or $O(k^{4}+h^{r})$ (ETD4-Padé) in the $L^2$ norm, respectively. Numerical experiments are presented to demonstrate the robustness of the proposed numerical schemes.     

Convergence analysis of a monotonic penalty method for American option pricing

This paper is devoted to study the convergence analysis of a monotonic penalty method for pricing American options. A monotonic penalty method is first proposed to solve the complementarity problem arising from the valuation of American options, which produces a nonlinear degenerated parabolic PDE with Black-Scholes operator. Based on the variational theory, the solvability and convergence properties of this penalty approach are established in a proper infinite dimensional space. Moreover, the convergence rate of the combination of two power penalty functions is obtained.     

Power Penalty Method for a Linear Complementarity Problem Arising from American Option Valuation

In this paper, we present a power penalty function approach to the linear complementarity problem arising from pricing American options. The problem is first reformulated as a variational inequality problem; the resulting variational inequality problem is then transformed into a nonlinear parabolic partial differential equation (PDE) by adding a power penalty term. It is shown that the solution to the penalized equation converges to that of the variational inequality problem with an arbitrary order. This arbitrary-order convergence rate allows us to achieve the required accuracy of the solution with a small penalty parameter. A numerical scheme for solving the penalized nonlinear PDE is also proposed. Numerical results are given to illustrate the theoretical findings and to show the effectiveness and usefulness of the method. This work was partially supported by a research grant from the University of Western Australia and the Research Grant Council of Hong Kong, Grants PolyU BQ475 and PolyU BQ493.     

Convergence analysis of power penalty method for American bond option pricing

This paper is concerned with the convergence analysis of power penalty method to pricing American options on discount bond, where the single factor Cox–Ingrosll–Ross model is adopted for the short interest rate. The valuation of American bond option is usually formulated as a partial differential complementarity problem. We first develop a power penalty method to solve this partial differential complementarity problem, which produces a nonlinear degenerated parabolic PDE. Within the framework of variational inequalities, the solvability and convergence properties of this penalty approach are explored in a proper infinite dimensional space. Moreover, a sharp rate of convergence of the power penalty method is obtained. Finally, we show that the power penalty approach is monotonically convergent with the penalty parameter.     

指数时程差分与有理谱配点法求解奇异摄动Burgers-Huxley问题

带小参数ε的Burgers-Huxley方程是一类非线性、非定常奇异摄动初边值问题,本文用指数时程差分与有理谱配点法求其数值解.对空间方向的边界层,用带sinh变换的有理谱配点法便Chebyshev节点在边界层处加密,只需取较少节点即可达到较高精度;时间方向采用指数时程差分与4阶Runge-Kutta法相结合的格式,并用围线积分计算矩阵甬数的方法克服了求解奇异摄动问题时遇到的的数值不稳定堆题.数值实验表明,本文提出的方法在求解左、右边界层和内部层的奇异摄动Burgers-Huxley问题都有较高的精度.     

美式利率期权定价的抛物型变分不等式

应用PDE方法对美式利率期权定价问题进行理论分析.在CIR利率模型下美式利率期权定价问题可归结为一个退化的一维抛物型变分不等式.通过引入惩罚函数证明了该变分不等式的解的存在唯一性,然后研究了自由边界的一些性质,如单调性,光滑性和自由边界在终止期的位置.     

Partial differential integral equation model for pricing American option under multi state regime switching with jumps

In this paper, we consider a two dimensional partial differential integral equation (PDIE) model for pricing American option. A nonlinear rationality parameter function for two asset problems is introduced to deal with the free boundary. The rationality parameter function is added in the PDIEs used for pricing American option problems under multi-state regime switching with jumps. The resulting two dimensional nonlinear system of PDIE is then numerically solved. Based on real poles rational approximation, a strongly stable highly efficient and reliable method is developed to solve such complicated systems of PIDEs. The method is build in a predictor corrector style which makes it linearly implicit, therefore, avoids solving nonlinear systems of equations at each time step in all regimes. The method is seen to maintain the stability and convergence for large jump sizes and high volatility in each regime. The impact of regime switching on option prices corresponding to different values interest rate, volatility, and rationality parameter is computed, illustrated by graphs and given in the tables. Convergence results in each regime are presented and time evolution graphs are given to show the effectiveness and reliability of the method.     

Evaluating American put options on zero-coupon bonds by a penalty method

In this paper, American put options on zero-coupon bonds are priced under a single factor model of short-term rate. The linear complementarity problem of the option value is solved numerically by a penalty method, by which the problem is transformed into a nonlinear PDE by adding a power penalty term. The solution of the penalized problem converges to that of the original problem. A numerical scheme is established by using the finite volume method and the corresponding stability and convergence are discussed. Numerical results are presented to show the usefulness of the method.     

Differential quadrature method for pricing American options

In this article, differential quadrature method (DQM), a highly accurate and efficient numerical method for solving nonlinear problems, is used to overcome the difficulty in determining the optimal exercise boundary of American option. The following three parts of the problem in pricing American options are solved. The first part is how to treat the uncertainty of the early exercise boundary, or free boundary in the language of the PDE treatment of the American option, because American options can be exercised before the date of expiration. The second part is how to solve the nonlinear problem, because the problem of pricing American options is nonlinear. And the third part is how to treat the initial value condition with the singularity and the boundary conditions in the DQM. Numerical results for the free boundary of American option obtained by both DQM and finite difference method (FDM) are given and from which it can be seen the computational efficiency is greatly improved by DQM. © 2002 Wiley Periodicals, Inc. Numer Methods Partial Differential Eq 18: 711–725, 2002; Published online in Wiley InterScience (www.interscience.wiley.com); DOI 10.1002/num.10028.     

An efficient numerical approach to solve a class of variable‐order fractional integro‐partial differential equations

The main purpose of this work is to investigate an initial boundary value problem related to a suitable class of variable order fractional integro‐partial differential equations with a weakly singular kernel. To discretize the problem in the time direction, a finite difference method will be used. Then, the Sinc‐collocation approach combined with the double exponential transformation is employed to solve the problem in each time level. The proposed numerical algorithm is completely described and the convergence analysis of the numerical solution is presented. Finally, some illustrative examples are given to demonstrate the pertinent features of the proposed algorithm.     

An explicit spectral collocation method using nonpolynomial basis functions for the time‐dependent Schrödinger equation

We propose a spectral collocation method for the numerical solution of the time‐dependent Schrödinger equation, where the newly developed nonpolynomial functions in a previous study are used as basis functions. Equipped with the new basis functions, various boundary conditions can be imposed exactly. The preferable semi‐implicit time marching schemes are employed for temporal discretization. Moreover, the new basis functions build in a free parameter λ intrinsically, which can be chosen properly so that the semi‐implicit scheme collapses to an explicit scheme. The method is further applied to linear Schrödinger equation set in unbounded domain. The transparent boundary conditions are constructed for time semidiscrete scheme of the linear Schrödinger equation. We employ spectral collocation method using the new basis functions for the spatial discretization, which allows for the exact imposition of the transparent boundary conditions. Comprehensive numerical tests both in bounded and unbounded domain are performed to demonstrate the attractive features of the proposed method.     

American Call Options Under Jump‐Diffusion Processes – A Fourier Transform Approach

We consider the American option pricing problem in the case where the underlying asset follows a jump‐diffusion process. We apply the method of Jamshidian to transform the problem of solving a homogeneous integro‐partial differential equation (IPDE) on a region restricted by the early exercise (free) boundary to that of solving an inhomogeneous IPDE on an unrestricted region. We apply the Fourier transform technique to this inhomogeneous IPDE in the case of a call option on a dividend paying underlying to obtain the solution in the form of a pair of linked integral equations for the free boundary and the option price. We also derive new results concerning the limit for the free boundary at expiry. Finally, we present a numerical algorithm for the solution of the linked integral equation system for the American call price, its delta and the early exercise boundary. We use the numerical results to quantify the impact of jumps on American call prices and the early exercise boundary.     

Numerical solution of systems of partial integral differential equations with application to pricing options

We introduce and analyze a strongly stable numerical method designed to yield good performance under challenging conditions of irregular or mismatched initial data for solving systems of coupled partial integral differential equations (PIDEs). Spatial derivatives are approximated using second order central difference approximations by treating the mixed derivative terms in a special way. The integral operators are approximated using one and two–dimensional trapezoidal rule on an equidistant grid. Computational complexity of the method for solving large systems of PIDEs is discussed. A detailed treatment for the consistency, stability, and convergence of the proposed method is provided. Two asset American option under regime–switching with jump–diffusion model when solved using a penalty term, leads to a system of two dimensional PIDEs with mixed derivatives. This model involves double probability density function which brings more challenges to the numerical solution in already a complicated partial integral differential equation. The complexity of the dense jump probability generator, the nonlinear penalty term and the regime–switching terms are treated efficiently, while maintaining the stability and convergence of the method. The impact of the jump intensity and other parameters is shown in the graphs. Numerical experiments are performed to demonstrated efficiency, accuracy, and reliability of the proposed approach.     

An IMEX‐BDF2 compact scheme for pricing options under regime‐switching jump‐diffusion models

In this paper, an implicit‐explicit two‐step backward differentiation formula (IMEX‐BDF2) together with finite difference compact scheme is developed for the numerical pricing of European and American options whose asset price dynamics follow the regime‐switching jump‐diffusion process. It is shown that IMEX‐BDF2 method for solving this system of coupled partial integro‐differential equations is stable with the second‐order accuracy in time. On the basis of IMEX‐BDF2 time semi‐discrete method, we derive a fourth‐order compact (FOC) finite difference scheme for spatial discretization. Since the payoff function of the option at the strike price is not differentiable, the results show only second‐order accuracy in space. To remedy this, a local mesh refinement strategy is used near the strike price so that the accuracy achieves fourth order. Numerical results illustrate the effectiveness of the proposed method for European and American options under regime‐switching jump‐diffusion models.