A pseudospectral method for option pricing with transaction costs under exponential utility

DOI10.1016/J.CAM.2021.113541MaRDI QIDQ2029418zbMATH OpenOpenAlexWikidataFDO

Authors Javier de Frutos, Víctor Gatón

Publication date 3 June 2021

Published in Journal of Computational and Applied Mathematics (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/2103.05369

zbMATH Keywords

exponential utilityoption pricingspectral methodtransaction costs

Mathematics Subject Classification ID

Spectral, collocation and related methods for initial value and initial-boundary value problems involving PDEs (65M70) Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60)

Abstract: This paper concerns the design of a Fourier based pseudospectral numerical method for the model of European Option Pricing with transaction costs under Exponential Utility derived by Davis, Panas and Zariphopoulou. Computing the option price involves solving two stochastic optimal control problems. With a Exponential Utility function, the dimension of the problem can be reduced, but one has to deal with high absolute values in the objective function. In this paper, we propose two changes of variables that reduce the impact of the exponential growth. We propose a Fourier pseudospectral method to solve the resulting non linear equation. Numerical analysis of the stability, consistency, convergence and localization error of the method are included. Numerical experiments support the theoretical results. The effect of incorporating transaction costs is also studied.

Review text

The following dynamic model is known on the assumption that an investor holds an amount \(\overline X(t)\) in the bank account and \(\overline y(t)\) shares of a certain stock \(\overline S(t)\) \[ \begin{array}{l} d\overline X(t)=r \overline X(t)dt - (1+\lambda)\overline S(t)d\overline L(t)+(1-\mu)\overline S(t)d\overline M(t),\\ d\overline y(t)=d \overline L(t)-d\overline M(t),\\ d\overline S(t)=\overline S(t) \alpha dt+\overline S(t) \sigma dz_t,\\ \end{array} \] where \(r\) is the constant risk-free rate, \(\alpha\) is the constant expected rate of return of the stock, \(\sigma>0\) is the constant volatility of the stock and \(z_t\) is the standard Brownian motion. \(\overline L(t)\) and \(\overline M(t)\) are adapted, right-continuous, nonnegative and nondecreasing processes. The authors propose two changes of variables that reduce the impact of the exponential growth and a Fourier pseudospectral method to solve the resulting nonlinear equation. Numerical analysis of the stability of the method is included.

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Cites work

• A Fourier cosine method for an efficient computation of solutions to BSDEs
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• Evaluation of American option prices in a path integral framework using Fourier-Hermite series expansions
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• Option Pricing Under GARCH Processes Using PDE Methods
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• Spectral Methods
• The pricing of options and corporate liabilities
• There is no nontrivial hedging portfolio for option pricing with transaction costs

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