Dirichlet forms and finite element methods for the SABR model

DOI10.1137/16M1066117zbMATH Open1395.91498arXiv1801.02719OpenAlexW2963186900WikidataQ129734491 ScholiaQ129734491MaRDI QIDQ4579839FDOQ4579839

Authors: Blanka Horvath, Oleg Reichmann 

Publication date: 10 August 2018

Published in: SIAM Journal on Financial Mathematics (Search for Journal in Brave)

Abstract: We propose a deterministic numerical method for pricing vanilla options under the SABR stochastic volatility model, based on a finite element discretization of the Kolmogorov pricing equations via non-symmetric Dirichlet forms. Our pricing method is valid under mild assumptions on parameter configurations of the process both in moderate interest rate environments and in near-zero interest rate regimes such as the currently prevalent ones. The parabolic Kolmogorov pricing equations for the SABR model are degenerate at the origin, yielding non-standard partial differential equations, for which conventional pricing methods ---designed for non-degenerate parabolic equations--- potentially break down. We derive here the appropriate analytic setup to handle the degeneracy of the model at the origin. That is, we construct an evolution triple of suitably chosen Sobolev spaces with singular weights, consisting of the domain of the SABR-Dirichlet form, its dual space, and the pivotal Hilbert space. In particular, we show well-posedness of the variational formulation of the SABR-pricing equations for vanilla and barrier options on this triple. Furthermore, we present a finite element discretization scheme based on a (weighted) multiresolution wavelet approximation in space and a $heta$-scheme in time and provide an error analysis for this discretization.

Full work available at URL: https://arxiv.org/abs/1801.02719

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zbMATH Keywords

Dirichlet formsfinite element methodsSABR model

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60) Initial value problems for second-order parabolic equations (35K15) Stability and convergence of numerical methods for initial value and initial-boundary value problems involving PDEs (65M12) Finite element, Rayleigh-Ritz and Galerkin methods for initial value and initial-boundary value problems involving PDEs (65M60)

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• Effective Markovian projection: application to CMS spread options and mid-curve swaptions
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