The Stability Analysis of Predictor–Corrector Method in Solving American Option Pricing Model

R. Kalantari (), S. Shahmorad () and D. Ahmadian ()

Computational Economics, 2016, vol. 47, issue 2, 255-274

Abstract: In this paper, a new technique is investigated to speed up the order of accuracy for American put option pricing under the Black–Scholes (BS) model. First, we introduce the mathematical modeling of American put option, which leads to a free boundary problem. Then the free boundary is removed by adding a small and continuous penalty term to the BS model that cause American put option problem to be solvable on a fixed domain. In continuation we construct the method of lines (MOL) in space and reach a non-linear problem and we show that the proposed MOL is more stable than the other kinds. To deal with the non-linear problem, an algorithm is used based on the predictor–corrector method which corresponds to two parameters, $$\theta $$ θ and $$\phi $$ ϕ . These parameters are chosen optimally using a rational approximation to determine the order of time convergence. Finally in numerical results a second order convergence is shown in both space and time variables. Copyright Springer Science+Business Media New York 2016

Keywords: Penalty method; American option pricing; Finite difference method; Rational approximation; Method of lines; Predictor–Corrector method (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1007/s10614-015-9483-x

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