Evaluating American put options on zero-coupon bonds by a penalty method

Evaluating American put options on zero-coupon bonds by a penalty method

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Article ID: iaor20133288
Volume: 235
Issue: 13
Start Page Number: 3921
End Page Number: 3931
Publication Date: May 2011
Journal: Journal of Computational and Applied Mathematics
Authors: , ,
Keywords: simulation
Abstract:

In this paper, American put options on zero‐coupon bonds are priced under a single factor model of short‐term rate. The linear complementarity problem of the option value is solved numerically by a penalty method, by which the problem is transformed into a nonlinear PDE by adding a power penalty term. The solution of the penalized problem converges to that of the original problem. A numerical scheme is established by using the finite volume method and the corresponding stability and convergence are discussed. Numerical results are presented to show the usefulness of the method.

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