Computational Economics

, Volume 43, Issue 4, pp 463–483 | Cite as

A Robust Numerical Scheme For Pricing American Options Under Regime Switching Based On Penalty Method

Article
First Online:
Accepted:

Abstract

This paper is devoted to develop a robust numerical method to solve a system of complementarity problems arising from pricing American options under regime switching. Based on a penalty method, the system of complementarity problems are approximated by a set of coupled nonlinear partial differential equations (PDEs). We then introduce a fitted finite volume method for the spatial discretization along with a fully implicit time stepping scheme for the PDEs, which results in a system of nonlinear algebraic equations. We show that this scheme is consistent, stable and monotone, hence convergent. To solve the system of nonlinear equations effectively, an iterative solution method is established. The convergence of the solution method is shown. Numerical tests are performed to examine the convergence rate and verify the effectiveness and robustness of the new numerical scheme.

Keywords

American option pricing Regime switching Penalty method Finite volume method 
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Notes

Acknowledgments

Project 11001178 supported by National Natural Science Foundation of China. This work was also partially supported by Foundation for Distinguished Young Talents in Higher Education of Guangdong, China (Grant No. WYM10099).

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Copyright information

© Springer Science+Business Media New York 2013

Authors and Affiliations

  1. 1.Business SchoolShenzhen UniversityShenzhenChina
  2. 2.Department of Mathematics and StatisticsThe Curtin University of TechnologyPerthAustralia
  3. 3.Marshall School of BusinessUniversity of Southern CaliforniaLos AngelesUSA

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