A predictor-corrector scheme based on the ADI method for pricing american puts with stochastic volatility. (English) Zbl 1228.91077

Zhu, Song-Ping; Chen, Wen-Ting

Comput. Math. Appl. 62, No. 1, 1-26 (2011).

Summary: We introduce a new numerical scheme, based on the ADI (alternating direction implicit) method, to price American put options with a stochastic volatility model. Upon applying a front-fixing transformation to transform the unknown free boundary into a known and fixed boundary in the transformed space, a predictor-corrector finite difference scheme is then developed to solve for the optimal exercise price and the option values simultaneously. Based on the local von Neumann stability analysis, a stability requirement is theoretically obtained first and then tested numerically. It is shown that the instability introduced by the predictor can be damped, to some extent, by the ADI method that is used in the corrector. The results of various numerical experiments show that this new approach is fast and accurate, and can be easily extended to other types of financial derivatives with an American-style exercise. Another key contribution of this paper is the proposition of a set of appropriate boundary conditions, particularly in the volatility direction, upon realizing that appropriate boundary conditions in the volatility direction for stochastic volatility models appear to be controversial in the literature. A sound justification is also provided for the proposed boundary conditions mathematically as well as financially.

MSC:

91G60	Numerical methods (including Monte Carlo methods)
91G20	Derivative securities (option pricing, hedging, etc.)
65M06	Finite difference methods for initial value and initial-boundary value problems involving PDEs

Keywords:

ADI scheme; stability analysis; American put options; Heston model

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