Adaptive and High-Order Methods for Valuing American Options

Abstract

We develop space-time adaptive and high-order methods for valuing American options using a partial differential equation (PDE) approach. The linear complementarity problemarising due to the free boundary is handled by a penalty method. Both finite difference and finite element methods are considered for the space discretization of the PDE, while classical finite differences, such as Crank-Nicolson, are used for the time discretization. The high-order discretization in space is based on an optimal finite element collocation method, the main computational requirements of which are the solution of one tridiagonal linear system at each time step, while the resulting errors at the gridpoints and midpoints of the space partition are fourth-order. To control the space error, we use adaptive gridpoint distribution based on an error equidistribution principle. A time stepsize selector is used to further increase the efficiency of the methods. Numerical examples show that our methods converge fast and provide highly accurate options prices, Greeks, and early exercise boundaries

Keywords: Adaptive Mesh Selection, Error Equidistribution, Quadratic Splines, Collocation, Finite Differences, European Option, American Option, Penalty Method

JEL Classification: E40, E43, G12, G13, C61, C63