A consistent stable numerical scheme for a nonlinear option pricing model in illiquid markets

Markets liquidity is an issue of very high concern in financial risk management. In a perfect liquid market the option pricing model becomes the well‐known linear Black–Scholes problem. Nonlinear models appear when transaction costs or illiquid market effects are taken into account. This paper deals with the numerical analysis of nonlinear Black–Scholes equations modeling illiquid markets when price impact in the underlying asset market affects the replication of a European contingent claim. Numerical analysis of a nonlinear model is necessary because disregarded computations may waste a good mathematical model. In this paper we propose a finite‐difference numerical scheme that guarantees positivity of the solution as well as stability and consistency.