Convergence of the two point flux approximation method and the fitted two point flux approximation method for options pricing with local volatility function

DOI10.1016/J.CNSNS.2024.108291MaRDI QIDQ6604201zbMATH OpenFDO

Authors Rock Stephane Koffi, Antoine Tambue

Publication date 12 September 2024

Published in Communications in Nonlinear Science and Numerical Simulation (Search for Journal in Brave)

Full work available at URL https://doi.org/10.1016/J.CNSNS.2024.108291

zbMATH Keywords

finite volume methodlocal volatilityoption pricingPDEtwo-point flux approximation

Mathematics Subject Classification ID

Stopping times; optimal stopping problems; gambling theory (60G40) Finite volume methods for initial value and initial-boundary value problems involving PDEs (65M08) Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60)

Review text

In this article, the authors deal with numerical approximations for solving the Black-Scholes partial differential equation (PDE) for European and American options pricing with local volatility. More precisely, the authors give a rigorous convergence proof of a fully discretized scheme using the classical two-point flux approximation (TPFA) method for degenerated Black-Scholes operator in one dimension with local volatility function. Furthermore, the fitted-TPFA method for the degenerated Black-Scholes PDE by combining the classical TPFA method and the fitted finite volume method is derived and provide rigorous convergence proof of the fully discretized scheme where the time discretization is performed using the classical Euler methods. The fitted finite volume method is used when the stock price approaches zero with the goal to handle the degeneracy of the PDE while the TPFA method is used on the rest of space domain. Numerical experiments to support theoretical results for European and American options are provided in Section 5.

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Cites work

• A novel fitted finite volume method for the Black-Scholes equation governing option pricing
• An exponential integrator for finite volume discretization of a reaction-advection-diffusion equation
• BENCHOP -- the benchmarking project in option pricing
• Convergence of a fitted finite volume method for the penalized Black-Scholes equation governing European and American option pricing
• Finite element method for hemivariational inequalities. Theory, methods and applications
• Finite volume methods
• Option pricing: A simplified approach
• Power penalty method for a linear complementarity problem arising from American option valuation
• The pricing of options and corporate liabilities

Cited in

(1)

• Convergence of a fitted finite volume method for pricing two dimensional assets with stochastic volatilities

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