A finite difference scheme for option pricing in jump diffusion and exponential Lévy models. (English) Zbl 1101.47059

Cont, Rama; Voltchkova, Ekaterina

SIAM J. Numer. Anal. 43, No. 4, 1596-1626 (2005).

The authors propose a finite difference approach to finding the solution of a parabolic partial integro-differential equation (PIDE) with possible singular kernels. This problem is discussed within the framework of the option pricing of an underlying random asset that is driven by a Lévy process or a more general time-inhomogeneous jump-diffusion model. Solving the aforementioned PIDE by finite difference methods involves several approximations such as the localization of the PIDE to a bounded domain, treatment of the singularity arising from small jumps, discretization of the equation in space and iteration in time.
The paper provides a discussion of localization errors and an estimate for such errors under an integrability condition on the Lévy measure. In this context, the authors propose an explicit-implicit finite difference scheme for which issues related to the pricing of European and barrier options, consistency, stability and convergence are discussed. By way of conclusion, numerical tests are done for smooth and nonsmooth initial conditions in order to determine the effect of various numerical parameters on the accuracy of the finite difference method.

Reviewer: Mark A. Petersen (Potchefstroom)

MSC:

47N10	Applications of operator theory in optimization, convex analysis, mathematical programming, economics
47G20	Integro-differential operators
65M06	Finite difference methods for initial value and initial-boundary value problems involving PDEs
65M12	Stability and convergence of numerical methods for initial value and initial-boundary value problems involving PDEs
49L25	Viscosity solutions to Hamilton-Jacobi equations in optimal control and differential games
60H30	Applications of stochastic analysis (to PDEs, etc.)
60G51	Processes with independent increments; Lévy processes
91G60	Numerical methods (including Monte Carlo methods)

Keywords:

parabolic integro-differential equations; finite difference methods; Lévy process; jump-diffusion models; option pricing; viscosity solutions