Numerical simulation for European and American option of risks in climate change of Three Gorges Reservoir Area (Q2146438)

The authors first establish a real option model with sea level and temperature as the target assets to evaluate the potential opportunities in the risk management of sea level rising. By using Itô's lemma and the non-arbitrage pricing principle, the real option model depending on time independent two-dimensional linear parabolic variational inequalities is obtained. In view of European and American real options, the issue switched into a parabolic variational inequalities. Subsequently, a power penalty approach is proposed to transform it into a nonlinear parabolic equation. It is shown that the solutions of the nonlinear parabolic equation is unique and it converges to the solution of the parabolic variational inequalities. A fitted finite volume method is developed to solve the nonlinear parabolic equation in the case of European and American options, and the convergence of the nonlinear parabolic equation is obtained. Some numerical tests are presented to support the theoretical results.