Summary.
The fair price for an American option where the underlying asset follows a jump diffusion process can be formulated as a partial integral differential linear complementarity problem. We develop an implicit discretization method for pricing such American options. The jump diffusion correlation integral term is computed using an iterative method coupled with an FFT while the American constraint is imposed by using a penalty method. We derive sufficient conditions for global convergence of the discrete penalized equations at each timestep. Finally, we present numerical tests which illustrate such convergence.
Similar content being viewed by others
References
Amadori, A.L.: The obstacle problem for nonlinear integro-differential equations arising in option pricing. Working paper, Istituto pre le Applicazione del Calcolo ‘‘M. Picone’’, Rome, www.iac.rm.cnr.it/∼amadori
Amin, K.: Jump diffusion option valuation in discrete time. J. Finance 48, 1833–1863 (1993)
Andersen, L., Andreasen, J.: Jump-diffusion processes: Volatility smile fitting and numerical methods for option pricing. Rev. Derivatives Res. 4, 231–262 (2000)
Ayache, E., Forsyth, P.A., Vetzal, K.R.: Next generation models for convertible bonds with credit risk. Wilmott Magazine, December 2002, pp. 68–77
Barles, G.: Convergence of numerical schemes for degenerate parabolic equations arising in finance. In L.C.G. Rogers and D. Talay, (eds.), Numerical Methods in Finance, Cambridge University Press, Cambridge, 1997, pp. 1–21
Briani, M., La Chioma, C., Natalini, R.: Convergence of numerical schemes for viscosity solutions to integro-differential degenerate parabolic problems arising in financial theory. Working paper, Istituto pre le Applicazione del Calcolo ‘‘M. Picone’’, Rome, www.iac.rm.cnr.it/∼natalini, to appear in Numerische Mathematik
Broadie, M., Yamamoto, Y.: Application of the Fast Gauss transform to option pricing. Working paper, Columbia School of Business, 2002
Coleman, T.F., Li, Y., Verma, A.: Reconstructing the unknown local volatility function. J. Comput. Finance 2, 77–102 (1999)
Cottle, R.W., Pang, J.-S., Stone, R.E: The Linear Complementarity Problem. Academic Press, 1992
Crandall, M.G., Ishii, H., Lions, P.L.: User’s guide to viscosity solutions of second order partial differential equations. Bulletin of the Am. Math. Soc. 27, 1–67 July 1992
Cryer, C.W.: The efficient solution of linear complementarity problems for tridiagonal Minkowski matrices. ACM Trans. Math. Softw. 9, 199–214 (1983)
d’Halluin, Y., Forsyth, P.A., Vetzal, K.R.: Robust numerical methods for contingent claims under jump diffusion processes. www.scicom.uwaterloo.ca/∼paforsyt/jump.pdf, submitted to IMA J. Numer. Anal.
d’Halluin, Y., Forsyth, P.A., Vetzal, K.R., Labahn, G.: A numerical PDE approach for pricing callable bonds. Appl. Math. Finance 8, 49–77 (2001)
Dutt, A., Rokhlin, V.: Fast Fourier transforms for nonequispaced data. SIAM J. Sci. Comput. 14, 1368–1393 November 1993
Elliot, E.M., Ockendon, J.R.: Weak and Variational Methods for Moving Boundary Problems. Pitman, 1982
Forsyth, P.A., Vetzal, K.R.: Quadratic convergence of a penalty method for valuing American options. SIAM J. Sci. Comput. 23, 2096–2123 (2002)
Greengard, L., Strain, J.: The fast Gauss transform. SIAM J. Sci. Comput. 12, 79–94 (1991)
Hull, J.: Options, Futures, and Other Derivatives. Prentice Hall, Inc., Upper Saddle River, NJ, 3rd edition, 1997
Johnson, C.: Numerical Solutions of Partial Differential Equations By the Finite Element Method. Cambridge University Press, Cambridge, 1987
Kangro, R., Nicolaides, R.: Far field boundary conditions for Black-Scholes equations. SIAM J. Numer. Anal. 38(4), 1357–1368 (2000)
Lewis, A.: Fear of jumps. Wilmott Magazine, December 2002, pp. 60–67
Merton, R.C.: Option pricing when underlying stock returns are discontinuous. J. Financial Econ. 3, 125–144 (1976)
Meyer, G.H.: The numerical valuation of options with underlying jumps. Acta Math. Univ. Comenianae 67, 69–82 (1998)
Mulinacci, S.: An approximation of American option prices in a jump diffusion model. Stochastic Processes and their Applications 62, 1–17 (1996)
Pham, H.: Optimal stopping of controlled jump diffusion processes: a viscosity solution approach. J. Math. Syst. Estimation and Control 8, 1–27 (1998)
Pooley, D.M., Forsyth, P.A., Vetzal, K.R.: Numerical convergence properties of option pricing PDEs with uncertain volatility. IMA J. Numer. Anal. 23, 241–267 (2003)
Potts, D., Steidl, G., Tasche, M.: Fast Fourier transforms for nonequispaced data: A tutorial. In: Modern Sampling Theory: Mathematics and Application, J.J. Benedetto and P. Ferreira, (eds.), ch. 12, Birkhauser, 2000 , pp. 253–274
Press, W.H., Flannery, B.P., Teukolsky, S.A., Vetterling, W.T.: Numerical Recipes: The Art of Scientific Computing. Cambridge University Press, Cambridge (UK) and New York, 2nd edition, 1992
Rannacher, R.: Finite element solution of diffusion problems with irregular data. Numer. Math. 43, 309–327 (1984)
Tavella, D., Randall, C.: Pricing financial instruments: the finite difference method. John Wiley & Sons, Inc, 2000
Vazquez, A.A., Oosterlee, C.W.: Numerical valuation of options with jumps in the underlying. Working paper, Delft University of Technology, 2003
Ware, A.F.: Fast approximate Fourier transforms for irregularly spaced data. SIAM Rev. 40, 838–856 (1998)
Wilmott, P.: Derivatives. John Wiley and Sons Ltd, Chichester, 1998
Windcliff, H., Forsyth, P.A., Vetzal, K.R.: Shout options: a framework for pricing contracts which can be modified by the investor. J. Comput. Appl. Math. 134, 213–241 (2001)
Windcliff, H., Forsyth, P.A., Vetzal, K.R.: Valuation of segregated funds: shout options with maturity extensions. Insurance: Math. Econ. 29, 1–21 (2001)
Windcliff, H., Forsyth, P.A., Vetzal, K.R.: Analysis of the stability of the linear boundary condition for the Black-Scholes equation, 2003. Submitted to the J. of Comput. Finance
Zhang, X.L.: Numerical analysis of American option pricing in a jump-diffusion model. Math. Oper. Res. 22, 668–690 (1997)
Zvan, R., Forsyth, P.A., Vetzal, K.R.: Penalty methods for American options with stochastic volatility. J. Comput. Appl. Math. 91, 199–218 (1998)
Zvan, R., Forsyth, P.A., Vetzal, K.R.: Discrete Asian barrier options. J. Comput. Finance 3(Fall), 41–67 (1999)
Zvan, R., Forsyth, P.A., Vetzal, K.R.: A finite element approach to the pricing of discrete lookbacks with stochastic volatility. Appl. Math. Finance 6, 87–106 (1999)
Zvan, R., Forsyth, P.A., Vetzal, K.R.: A finite volume approach for contingent claims valuation. IMA J. Numer. Anal. 21, 703–731 (2001)
Author information
Authors and Affiliations
Corresponding author
Additional information
Mathematics Subject Classification (1991): 65M12, 65M60, 91B28
Correspondence to: P.A. Forsyth
Rights and permissions
About this article
Cite this article
d’Halluin, Y., Forsyth, P. & Labahn, G. A penalty method for American options with jump diffusion processes. Numer. Math. 97, 321–352 (2004). https://doi.org/10.1007/s00211-003-0511-8
Received:
Revised:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s00211-003-0511-8