Boundary Evolution Equations for American Options
37 Pages Posted: 2 Dec 2011 Last revised: 12 Jan 2012
Date Written: November 30, 2011
We consider the problem of finding optimal exercise policies for American options, both under constant and stochastic volatility settings. Rather than work with the usual equations that characterize the price exclusively, we derive and use boundary evolution equations that characterize the evolution of the optimal exercise boundary. Using these boundary evolution equations we show how one can construct very efficient computational methods for pricing American options that avoid common sources of error. First we detail a methodology for standard static grids and then describe an improvement that defines a grid that evolves dynamically while solving the problem. When integral representations are available, as in the Black-Scholes setting, we also describe a modified integral method that leverages on the representation to solve the boundary evolution equations. Finally we compare runtime and accuracy to other popular numerical methods. The ideas and methodology presented herein can easily be extended to other optimal stopping problems.
Keywords: Optimal Stopping, American Options, Stochastic Volatility, Early Exercise Boundary, Free-Boundary Problem, Dynamic Grid
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