On the use of policy iteration as an easy way of pricing American options

DOI10.1137/110823328zbMATH Open1257.91051arXiv1012.4976OpenAlexW3103664326MaRDI QIDQ4902222FDOQ4902222

Authors: J. H. Witte, C. Reisinger 

Publication date: 25 January 2013

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

Abstract: In this paper, we demonstrate that policy iteration, introduced in the context of HJB equations in [Forsyth & Labahn, 2007], is an extremely simple generic algorithm for solving linear complementarity problems resulting from the finite difference and finite element approximation of American options. We show that, in general, O(N) is an upper and lower bound on the number of iterations needed to solve a discrete LCP of size N. If embedded in a class of standard discretisations with M time steps, the overall complexity of American option pricing is indeed only O(N(M+N)), and, therefore, for M N, identical to the pricing of European options, which is O(MN). We also discuss the numerical properties and robustness with respect to model parameters in relation to penalty and projected relaxation methods.

Full work available at URL: https://arxiv.org/abs/1012.4976

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zbMATH Keywords

numerical solutionAmerican optionlinear complementarity problempolicy iteration

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60) Numerical solution of discretized equations for initial value and initial-boundary value problems involving PDEs (65M22)

Cited In (21)

• A policy iteration algorithm for the American put option and free boundary control problems
• Anderson Acceleration for Nonsmooth Fixed Point Problems
• A finite difference scheme for variational inequalities arising in stochastic control problems with several singular control variables
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• A fixed point method for the linear complementarity problem arising from American option pricing
• Dynamic intertemporal utility optimization by means of Riccati transformation of Hamilton-Jacobi-Bellman equation
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• PRICING AMERICAN OPTIONS WITH THE RUNGE–KUTTA–LEGENDRE FINITE DIFFERENCE SCHEME
• Stabilized explicit Runge-Kutta methods for multi-asset American options
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• Investment flexibility as a barrier to entry
• Modulus-based successive overrelaxation iteration method for pricing American options with the two-asset Black-Scholes and Heston's models based on finite volume discretization

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