Pricing equity options everywhere

S. Dyrting

Quantitative Finance, 2004, vol. 4, issue 6, 663-676

Abstract: Finite difference methods are a popular technique for pricing American options. Since their introduction to finance by Brennan and Schwartz their use has spread from vanilla calls and puts on one stock to path-dependent and exotic options on multiple assets. Despite the breadth of the problems they have been applied to, and the increased sophistication of some of the newer techniques, most approaches to pricing equity options have not adequately addressed the issues of unbounded computational domains and divergent diffusion coefficients. In this article it is shown that these two problems are related and can be overcome using multiple grids. This new technique allows options to be priced for all values of the underlying, and is illustrated using standard put options and the call on the maximum of two stocks. For the latter contract, I also derive a characterization of the asymptotic continuation region in terms of a one-dimensional option pricing problem, and give analytic formulae for the perpetual case.

Date: 2004
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DOI: 10.1080/14697680500039142

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