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Multigrid Iterative Algorithm based on Compact Finite Difference Schemes and Hermite interpolation for Solving Regime Switching American Options

Chinonso Nwankwo and Weizhong Dai

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Abstract: We present a multigrid iterative algorithm for solving a system of coupled free boundary problems for pricing American put options with regime-switching. The algorithm is based on our recently developed compact finite difference scheme coupled with Hermite interpolation for solving the coupled partial differential equations consisting of the asset option and the delta, gamma, and speed sensitivities. In the algorithm, we first use the Gauss-Seidel method as a smoother and then implement a multigrid strategy based on modified cycle (M-cycle) for solving our discretized equations. Hermite interpolation with Newton interpolatory divided difference (as the basis) is used in estimating the coupled asset, delta, gamma, and speed options in the set of equations. A numerical experiment is performed with the two- and four- regime examples and compared with other existing methods to validate the optimal strategy. Results show that this algorithm provides a fast and efficient tool for pricing American put options with regime-switching.

Date: 2020-08, Revised 2021-08
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Handle: RePEc:arx:papers:2008.00925