Finite element and discontinuous Galerkin methods with perfect matched layers for American options

Haiming Song, Kai Zhang*, Yutian LI

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

5 Citations (Scopus)

Abstract

This paper is devoted to the American option pricing problem governed by the Black-Scholes equation. The existence of an optimal exercise policy makes the problem a free boundary value problem of a parabolic equation on an unbounded domain. The optimal exercise boundary satisfies a nonlinear Volterra integral equation and is solved by a high-order collocation method based on graded meshes. This free boundary is then deformed to a fixed boundary by the front-fixing transformation. The boundary condition at infinity (due to the fact that the underlying asset's price could be arbitrarily large in theory), is treated by the perfectly matched layer technique. Finally, the resulting initial-boundary value problems for the option price and some of the Greeks on a bounded rectangular space-time domain are solved by a finite element method. In particular, for Delta, one of the Greeks, we propose a discontinuous Galerkin method to treat the discontinuity in its initial condition. Convergence results for these two methods are analyzed and several numerical simulations are provided to verify these theoretical results.

Original languageEnglish
Pages (from-to)829-851
Number of pages23
JournalNumerical Mathematics
Volume10
Issue number4
DOIs
Publication statusPublished - 1 Nov 2017

Scopus Subject Areas

  • Modelling and Simulation
  • Control and Optimization
  • Computational Mathematics
  • Applied Mathematics

User-Defined Keywords

  • American option
  • Discontinuous Galerkin method
  • Finite element method
  • Greeks
  • Optimal exercise boundary
  • Perfectly matched layer

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