The effect of nonsmooth payoffs on the penalty approximation of American options
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Publication:2873140
DOI10.1137/12087743XzbMATH Open1282.91330arXiv1008.0836OpenAlexW1997754871MaRDI QIDQ2873140FDOQ2873140
Authors: J. H. Witte, S. D. Howison, C. Reisinger 
Publication date: 23 January 2014
Published in: SIAM Journal on Financial Mathematics (Search for Journal in Brave)
Abstract: This article combines various methods of analysis to draw a comprehensive picture of penalty approximations to the value, hedge ratio, and optimal exercise strategy of American options. While convergence of the penalised solution for sufficiently smooth obstacles is well established in the literature, sharp rates of convergence and particularly the effect of gradient discontinuities (i.e., the omni-present `kinks' in option payoffs) on this rate have not been fully analysed so far. This effect becomes important not least when using penalisation as a numerical technique. We use matched asymptotic expansions to characterise the boundary layers between exercise and hold regions, and to compute first order corrections for representative payoffs on a single asset following a diffusion or jump-diffusion model. Furthermore, we demonstrate how the viscosity theory framework in [Jakobsen, 2006] can be applied to this setting to derive upper and lower bounds on the value. In a small extension to [Bensoussan & Lions, 1982], we derive weak convergence rates also for option sensitivities for convex payoffs under jump-diffusion models. Finally, we outline applications of the results, including accuracy improvements by extrapolation.
Full work available at URL: https://arxiv.org/abs/1008.0836
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Derivative securities (option pricing, hedging, etc.) (91G20) Stopping times; optimal stopping problems; gambling theory (60G40)
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