Optimal convergence rate of the explicit finite difference scheme for American option valuation (Q2390004): Difference between revisions

An optimal convergence rate \(\mathcal{O}(\Delta x)\) for an explicit finite difference scheme for a variational inequality problem is obtained under the stability condition \(\frac{\sigma^2 \Delta t}{\Delta x^2} \leq 1\) using completely PDE methods without using probability theory. As a corollary, a binomial tree scheme of an American put option (where \(\frac{\sigma^2 \Delta t}{\Delta x^2} = 1 \) is convergent unconditionally with the rate \(\mathcal{O}((\Delta t)^{\frac{1}{2}})\). The author's result includes the BTM as a special case.