A Novel Fourth-Order Finite Difference Scheme for European Option Pricing in the Time-Fractional Black–Scholes Model

Xin Cai and Yihong Wang ()
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Xin Cai: School of Statistics and Mathematics, Shanghai Lixin University of Accounting and Finance, Shanghai 201209, China
Yihong Wang: School of Statistics and Mathematics, Shanghai Lixin University of Accounting and Finance, Shanghai 201209, China

Mathematics, 2024, vol. 12, issue 21, 1-23

Abstract: This paper addresses the valuation of European options, which involves the complex and unpredictable dynamics of fractal market fluctuations. These are modeled using the α -order time-fractional Black–Scholes equation, where the Caputo fractional derivative is applied with the parameter α ranging from 0 to 1. We introduce a novel, high-order numerical scheme specifically crafted to efficiently tackle the time-fractional Black–Scholes equation. The spatial discretization is handled by a tailored finite point scheme that leverages exponential basis functions, complemented by an L1-discretization technique for temporal progression. We have conducted a thorough investigation into the stability and convergence of our approach, confirming its unconditional stability and fourth-order spatial accuracy, along with ( 2 − α ) -order temporal accuracy. To substantiate our theoretical results and showcase the precision of our method, we present numerical examples that include solutions with known exact values. We then apply our methodology to price three types of European options within the framework of the time-fractional Black–Scholes model: (i) a European double barrier knock-out call option; (ii) a standard European call option; and (iii) a European put option. These case studies not only enhance our comprehension of the fractional derivative’s order on option pricing but also stimulate discussion on how different model parameters affect option values within the fractional framework.

Keywords: time-fractional Black–Scholes equation; tailored finite point scheme; L1 discretization formula; exponential functions; European option pricing (search for similar items in EconPapers)
JEL-codes: C (search for similar items in EconPapers)
Date: 2024
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