Abstract
We approximate the price of the American put for jump diffusions by a sequence of functions, which are computed iteratively. This sequence converges to the price function uniformly and exponentially fast. Each element of the approximating sequence solves an optimal stopping problem for geometric Brownian motion, and can be numerically computed using the classical finite difference methods. We prove the convergence of this numerical scheme and present examples to illustrate its performance.
Similar content being viewed by others
References
Aitsahlia F, Runnemo A (2007) A canonical optimal stopping problem for American options under a double-exponential jump-diffusion model. J Risk 10: 85–100
Almendral A, Oosterlee C (2007) On American options under the variance gamma process. Appl Math Finance 14(2): 131–152
Amin KI (1993) Jump diffusion option valuation in discrete time. J Finance 48: 1833–1863
Andersen L, Andreasen J (2000) Jump-diffusion processes: volatility smile fitting and numerical methods for option pricing. Rev Derivatives Res 4(3): 231–262
Barone-Adesi G, Whaley RE (1987) Efficient analytic approximation of American option values. J Finance 42: 301–320
Bayraktar E (2008) A proof of the smoothness of the finite time horizon American put option for jump diffusions. SIAM J Control Optim (to appear). Available at http://arxiv.org/abs/math.OC/0703782
Bayraktar E, Xing H (2008) Analysis of the optimal exercise boundary of American options for jump diffusions. Technical report, University of Michigan. Available at http://arxiv.org/abs/0712.3323
Brennan MJ, Schwartz ES (1977) The valuation of American put options. J Finance 32(2): 449–462
Cont R, Voltchkova E (2005) A finite difference scheme for option pricing in jump diffusion and exponential Lévy models. SIAM J Numer Anal 43(4): 1596–1626
Cont R, Tankov P (2004) Financial modelling with jump processes. Chapman & Hall/CRC Financial Mathematics Series. Chapman & Hall/CRC, Boca Raton, FL
d’Halluin Y, Forsyth PA, Labahn G (2004) A penalty method for American options with jump diffusion processes. Numerische Mathematik 97(2): 321–352
d’Halluin Y, Forsyth PA, Vetzal KR (2005) Robust numerical methods for contingent claims under jump diffusion processes. IMA J Numer Anal 25(1): 87–112
Hirsa A, Madan D (2004) Pricing American options under variance gamma. J Comput Finance 7(2): 63–80
Kenneth RJ, Jaimungal S, Surkov V (2008) Fourier space time stepping for option pricing with Lévy models. J Comput Finance (to appear)
Jaillet P, Lamberton D, Lapeyre B (1990) Variational inequalities and the pricing of American options. Acta Applicandae Mathematicae 21(3): 263–289
Kou SG, Petrella G, Wang H (2005) Pricing path-dependent options with jump risk via laplace transforms. Kyoto Econ Rev 74: 1–23
Kou SG, Wang H (2004) Option pricing under a double exponential jump diffusion model. Manage Sci 50: 1178–1192
Merton RC (1976) Option pricing when the underlying stock returns are discontinuous. J Financ Econ 3: 125–144
Metwally SAK, Atiya AF (2003) Fast monte carlo valuation of barrier options for jump diffusion processes. In: Proceedings of the computational intelligence for financial engineering, pp 101–107
Wilmott P, Howison S, Dewynne J (1995) The mathematics of financial derivatives. Cambridge University Press, Cambridge, A student introduction
Yang C, Jiang L, Bian B (2006) Free boundary and American options in a jump-diffusion model. Eur J Appl Math 17(1): 95–127
Young DM (1971) Iterative solution of large linear system. Academic Press, New York
Zhang XL (1997) Valuation of American options in a jump-diffusion model. In: Numerical methods in finance. Publ. Newton Inst. Cambridge University Press, Cambridge, pp 93–114
Author information
Authors and Affiliations
Corresponding author
Additional information
This research is supported in part by the National Science Foundation.
Rights and permissions
About this article
Cite this article
Bayraktar, E., Xing, H. Pricing American options for jump diffusions by iterating optimal stopping problems for diffusions. Math Meth Oper Res 70, 505–525 (2009). https://doi.org/10.1007/s00186-008-0282-1
Received:
Revised:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s00186-008-0282-1