Reduced Order Models for Pricing European and American Options under Stochastic Volatility and Jump-Diffusion Models

Maciej Balajewicz and Jari Toivanen

Papers from arXiv.org

Abstract: European options can be priced by solving parabolic partial(-integro) differential equations under stochastic volatility and jump-diffusion models like Heston, Merton, and Bates models. American option prices can be obtained by solving linear complementary problems (LCPs) with the same operators. A finite difference discretization leads to a so-called full order model (FOM). Reduced order models (ROMs) are derived employing proper orthogonal decomposition (POD). The early exercise constraint of American options is enforced by a penalty on subset of grid points. The presented numerical experiments demonstrate that pricing with ROMs can be orders of magnitude faster within a given model parameter variation range.

Date: 2016-12
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