Pricing American Options Under Regime Switching Using Method of Lines

Abstract

This paper considers the American option pricing problem under regime-switching by using the method-of-lines (MOL) scheme. American option prices in each regime involve prices in all other regimes. We treat the prices from other regimes implicitly, thus guaranteeing consistency. Iterative procedures are required but very few iterative steps are needed in practice. Numerical tests demonstrate the robustness, accuracy and efficiency of the proposed numerical scheme. We compare our results with Buffington and Elliott (2002)'s analytical approximation under two regimes. Our MOL scheme provides improved results especially for out-of-the money options, possibly because they use a separation of variable approach to the PDEs which cannot hold around the early exercise region. We also compare our results with those of Khaliq and Liu (2009) and suggest that their implicit scheme can be improved.

Keywords: American option, regime switching, method of lines

JEL Classification: G13