A NOVEL NUMERICAL APPROACH OF COMPUTING AMERICAN OPTION

Abstract

It is well acknowledged that the European options can be valued by an analytic formula, but situation is quite different for the American options. Mathematically, the Black-Scholes model for the American option pricing is a free boundary problem of partial differential equation. This model is a non-linear problem; it has no closed form solution. Although approximate solutions may be obtained by some numerical methods, but the precision and stability are hard to control since they are largely affected by the singularity at the exercise boundary near expiration date. In this paper, we propose a new numerical method, namely SDA, to solve the pricing problem of the American options. Our new method combines the advantages of the Semi-analytical Method and the Sliced-fixed Boundary Finite Difference Method while overcomes demerits of the two. Using the SDA method, we can resolve the problems resulted from the singularity near the optimal exercise boundary. Numerical experiments show that the SDA method is more accurate and more stable than other numerical methods. In this paper, we focus on the American put options, but the proposed method is also applicable to other types of options.