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Zbl 0945.65005
Zvan, R.; Forsyth, P.A.; Vetzal, K.R.
Penalty methods for American options with stochastic volatility. (English)
[J] J. Comput. Appl. Math. 91, No.2, 199-218 (1998). ISSN 0377-0427

Summary: The American early exercise constraint can be viewed as transforming the original linear two-dimensional stochastic volatility option pricing partial differential equation (PDE) into a PDE with a nonlinear source term. Several methods are described for enforcing the early exercise constraint by using a penalty source term in the discrete equations. The resulting nonlinear algebraic equations are solved using an approximate Newton iteration. The solution of the Jacobian is obtained using an incomplete LU preconditioned conjugate gradient-like method. Some example computations are presented for option pricing problems based on a stochastic volatility model, including an exotic American chooser option written on a put and call with discrete double knockout barriers and discrete dividends.

MSC 2000:: *65C30 Stochastic differential and integral equations
91B24 Price theory and market structure
60H15 Stochastic partial differential equations
35R60 PDE with randomness
65M60 Finite numerical methods (IVP of PDE)

Keywords: penalty methods; PDE option pricing; finite element; American constraint; stochastic volatility; nonlinear; Newton iteration; preconditioned conjugate gradient-like method

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Zentralblatt MATH Berlin [Germany]