Stability and convergence analysis of discretizations of the Black-Scholes PDE with the linear boundary condition

DOI10.1093/IMANUM/DRS050MaRDI QIDQ5398457zbMATH OpenOpenAlexFDO

Authors Kim Volders, Karel J. in 't Hout

Publication date 28 February 2014

Published in IMA Journal of Numerical Analysis (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1208.5168

zbMATH Keywords

convergencestabilityBlack-Scholesfinite difference discretizationlinear boundary conditionspartial differential equations (PDE)

Mathematics Subject Classification ID

Numerical methods (including Monte Carlo methods) (91G60) Finite difference methods for initial value and initial-boundary value problems involving PDEs (65M06) Stability and convergence of numerical methods for initial value and initial-boundary value problems involving PDEs (65M12)

Abstract: In this paper we consider the stability and convergence of numerical discretizations of the Black-Scholes partial differential equation (PDE) when complemented with the popular linear boundary condition. This condition states that the second derivative of the option value vanishes when the underlying asset price gets large and is often applied in the actual numerical solution of PDEs in finance. To our knowledge, the only theoretical stability result in the literature up to now pertinent to the linear boundary condition has been obtained by Windcliff, Forsyth and Vetzal (2004) who showed that for a common discretization a necessary eigenvalue condition for stability holds. In this paper, we shall present sufficient conditions for stability and convergence when the linear boundary condition is employed. We deal with finite difference discretizations in the spatial (asset) variable and a subsequent implicit discretization in time. As a main result we prove that even though the maximum norm of exp(tM) ($tge0$) can grow with the dimension of the semidiscrete matrix M, this generally does not impair the convergence behavior of the numerical discretizations. Our theoretical results are illustrated by ample numerical experiments.

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Cited in

(9)

• Accuracy, robustness, and efficiency of the linear boundary condition for the Black-Scholes equations
• Stability of central finite difference schemes for the Heston PDE
• On the space discretization of PDEs with unbounded coefficients arising in financial mathematics. A case of one spatial dimension
• Space discretization of Cauchy problems for multidimensional PDEs with unbounded coefficients arising in financial mathematics
• Discretization of the Black-Scholes operator with a natural left-hand side boundary condition
• Stability of central finite difference schemes on non-uniform grids for the Black-Scholes equation
• An efficient variable step-size method for options pricing under jump-diffusion models with nonsmooth payoff function
• Conditions of convergence of European option prices in the Black-Scholes model
• Analysis of the truncated error in solving the Black-Scholes equation

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