An adaptive and explicit fourth order Runge-Kutta-Fehlberg method coupled with compact finite differencing for pricing American put options
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Publication:2231609
American put optionscompact finite difference methodfixed free boundarylogarithmic transformationoptimal exercise boundaryRunge-Kutta-Fehlberg method
Stopping times; optimal stopping problems; gambling theory (60G40) Algorithms for approximation of functions (65D15) Multistep, Runge-Kutta and extrapolation methods for ordinary differential equations (65L06) Mesh generation, refinement, and adaptive methods for ordinary differential equations (65L50) Finite difference methods for initial value and initial-boundary value problems involving PDEs (65M06) Mesh generation, refinement, and adaptive methods for the numerical solution of initial value and initial-boundary value problems involving PDEs (65M50) Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60)
Abstract: We propose an adaptive and explicit fourth-order Runge-Kutta-Fehlberg method coupled with a fourth-order compact scheme to solve the American put options problem. First, the free boundary problem is converted into a system of partial differential equations with a fixed domain by using logarithm transformation and taking additional derivatives. With the addition of an intermediate function with a fixed free boundary, a quadratic formula is derived to compute the velocity of the optimal exercise boundary analytically. Furthermore, we implement an extrapolation method to ensure that at least, a third-order accuracy in space is maintained at the boundary point when computing the optimal exercise boundary from its derivative. As such, it enables us to employ fourth-order spatial and temporal discretization with Dirichlet boundary conditions for obtaining the numerical solution of the asset option, option Greeks, and the optimal exercise boundary. The advantage of the Runge-Kutta-Fehlberg method is based on error control and the adjustment of the time step to maintain the error at a certain threshold. By comparing with some existing methods in the numerical experiment, it shows that the present method has a better performance in terms of computational speed and provides a more accurate solution.
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Cited in
(5)- On the efficiency of 5(4) RK-embedded pairs with high order compact scheme and Robin boundary condition for options valuation
- PRICING AMERICAN OPTIONS WITH THE RUNGE–KUTTA–LEGENDRE FINITE DIFFERENCE SCHEME
- Efficient adaptive strategies with fourth-order compact scheme for a fixed-free boundary regime-switching model
- Sixth-order compact differencing with staggered boundary schemes and \(3(2)\) Bogacki-Shampine pairs for pricing free-boundary options
- A kind of adaptive variable stepsize embedded Runge-Kutta pairs coupled with the sinc collocation method for solving the KdV equation
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