Convergence analysis of a monotonic penalty method for American option pricing (Q950483)

Under the non-arbitrage assumption the American option pricing problem can be stated as linear differential complementarity problem with a Black-Scholes differential operator. Using variational theory and corresponding weighted Sobolev spaces a coerciveness result can be shown, which gives the existence of a unique solution. Then a monotonic penalty approach is studied. The penalized problems are uniquely solvable and the solutions are sufficiently smooth. Convergence analysis follows (with full proofs). For a combination of two power penalty methods convergence rates can be given, containing several such rates for special penalty approaches.