Numerical Methods for PDE in Finance

Johanne Rasoloarison* Krishanchandra Parwani*

Pricing American Options

Abstract
Finite difference schemes can be used in several fields. Indeed, they are useful to find
approximations for many differential equations. For this project, we will treat the
case of the obstacle problem. A particular case of such a problem is given by the
American put option problem.

Keywords: American option, time discretization, Brennan and Schwartz algorithm,

Crank Nicolson scheme, Backward Differentiation Formula.

1. Introduction

Financial options are widely used in the field of finance [4]. A valuation of option
contracts has been a topic of research in the last decades and there exists various
type of mathematical models for the prices of different kinds of options. For many
of these models there are no analytical solution formulas available and hence,
numerical valuation techniques need to be employed.
One of the most famous model for the price of an American option is based on the
Black-Scholes partial differential equation [1]. The Black-Scholes partial differential
equation is time dependent and that is why the numerical time integration needs to
be considered. First-order accurate explicit and implicit Euler schemes are well
known methods for the time discretization [5], [6]. Although, the implicit scheme is
only first-order accurate, it has good stability properties.
The Black-Scholes partial differential equation contains variable coefficients for the
first-order and second-order spatial derivatives. The space discretization of this
type of partial differential equation may lead to numerical difficulties. It turns out
that the Black-Scholes partial differential equation can be transformed into a
constant coefficient diffusion equation and after that the space discretization
becomes easier; see [11], [6].
However, there exist lot of option pricing models where above mentioned trans
formation can not be done and therefore, the discretization of the convection-
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*Department of Mathematics, Universit Paris 1 Panthon-Sorbonne, Paris.
1
diffusion type Black-Scholes partial differential equation should be done. Hence,
the choice of the space discretization scheme for the option pricing problem
depends on the form of the partial differential equation which is in the case. We
prefer a basic finite difference scheme because of its simplicity and furthermore,
because it leads to a tri-diagonal space discretization matrix which enables the
efficient use of the LU decomposition.
The Crank-Nicolson method is second-order accurate in time and it is widely used
in financial problems [7]. Even though the scheme is unconditionally stable it can
produce undesired oscillations to numerical solutions [8], [9], [10]. One way to
improve the stability is that the time-stepping is started with a few implicit Euler
time steps and then continued with the Crank-Nicolson method.
The second-order backward difference formula which is considered in this paper is
L-stable second-order accurate time discretization [12], [13]. In numerical
experiments we show that this scheme lead to more accurate numerical solution
than the Crank-Nicolson method.
We start by introducing mathematical models for American call and put options.
The model considered is based on the Black-Scholes partial differential equation

!" !&" !"

%&' ( ) ( +' +, = 0 (1)
!# !* & !*

where the function ,(', 1) is the price of the option for a given underlying asset
value s at a given time t. Due to the early exercise possibility of American options
an additional constraint

,(', 1) 4(') (2)

has to be introduced in order to avoid arbitrage possibilities. Here, g is the payoff

function of the option contract. The price of the option is obtained by solving the
partial differential equation with the previous constraint, boundary conditions and a
final condition.
It is well known that there is a value Sf (t) for all t which divides the domain (0, )
into two subdomains (0, Sf (t)) and (Sf (t), ) in such a way that in one of these
subdomains the price of the option equals to the payoff function while in the other
region it is higher than the payoff. The price of the option satisfies the Black-Scholes
equation (1) in the subdomain where it is higher than the payoff. The function Sf (t)
is not known beforehand and it has to be found together with the price of the option.

2
Hence, the option pricing problem is a free boundary problem. The stock value Sf
(t) indicates when the option should be exercised.

2. American Put Option

An American put option gives a right to sell the underlying asset for the exercise
price K. The initial value problem related to the American put option is

5, 6 ( ( 5 ( , 5,
(' ) +' +, 0,
51 5' ( 5'
, ', 1 4 ' ,
(
5, 6 ( ( 5 , 5,
(' ) +' +, , 4 = 0,
51 5' ( 5'

where (x,t) [0, X] x [0, T], with the boundary conditions

v(0, t) = K and v(X,t) = 0,
and with the initial value v(x,0) = g(x). The payoff function for the put option
contract is g(x)= max(K-x, 0).
The solution v is equal to the payoff function at time t in the domain (0, Sf (t)), while
in the domain (Sf (t), X), it satisfies the Black-Scholes partial differential equation.
An American put option satisfies the partial differential equation below:

789 5# , + ;,, , < = 0 , 1, ' > 0, ?

, 1, BCDE = ,F 1 , 1 (0, ?)
,(1, BCHI ) = ,J 1 = 0, 1 (0, ?)
, 0, ' = < ' , ' >
With
)( (
;, = ' 5*,* , +'5* , + +,
2

What we want to do is to find an approximation of the solution ,(1, ') of this

differential equation, with 1 (0, ?) and ' (BCDE , BCHI ).

To solve this problem, we will use several methods that will be exposed through this
project. We will give every scheme, describe how it works and give the final results

3
when we run the code. At the end, we will compare them to determine the best
scheme to use.

3. Discretization of the Black-Scholes equation

In the following, we consider the discretization of the Black-Scholes partial
differential equation

!" !&" !"

%&' ( ) ( +' +, = 0 (1)
!# !* & !*

We apply a uniform grid for the computational domain [0, X] x [0, T] which is
formed with a space step x = X/(m + 1) and a time step t = T/n. Moreover, we
use the notation
(M)
,D , OD , 1M = , (8O, Q1),

where i = 0,.m +1 and j = 0,.n, for the numerical approximation of the

solution. The efficiency of numerical solution can be improved by coordinate
transformations or using non uniform grids [14], [7]. For simplicity we do not
consider such approaches here, but the proposed methods can be readily extended
for these techniques.

3.1 Time discretization

Next, we consider the Crank-Nicolson scheme, the second-order backward
difference formula (BDF2). In the option pricing problems, the stability of the time
discretization scheme is an important property because of the non-smooth initial
data. The stability of time discretization schemes is considered in [12], [9]. It is
demonstrated that in certain type of problems the Crank-Nicolson method
performs poorly while L-stable methods are more accurate.

The Crank-Nicolson time discretization scheme can be interpreted to be the

average of the implicit and explicit Euler schemes. The scheme
6 6
, (MS6) , (M) + T , (MS6) + , (M) = 0, where the matrix B is tridiagonal.
R# (

is second-order accurate and unconditionally stable [7]. Despite this stability

property, it has been noticed, for example in [8], [9], [15], that certain types of initial
value can lead to numerical solutions with oscillations. One possible way to prevent
the oscillation problem is to start the time-stepping by a finite number of implicit
steps and then continue it with the Crank-Nicolson scheme [8], [16].

4
4. Models for American Put Option

A) Explicit Euler Scheme

This approach consists of solving the following problem

U ES6 U E
789 + ;U E + W 1E , U ES6 4 = 0 , 9 = 0, . , Z 1
V1

U\ = 4

Which is equivalent to

UDES6 = max(UDE V1(;U E + W 1E )D , 4D ) , 1 8 a

Depending on the values of the parameters, the scheme can be stable or not. For
instance, for I=N=20, we obtain CFL = 0.882
So for this case, stability is satisfied.

For I=50 and N=20, we do not have stability. But even with a higher CFL, one
gets the same results for the errors.

B) Implicit Euler scheme

This scheme can be written as follows

U ES6 U E
min( + ;U ES6 + W 1E , U ES6 4) = 0 , 9 = 0, , Z 1
V1

U\ = 4

We have to solve 789 dO e, O 4 = 0

where d = af + V1; and e = U E V1W(1ES6 )

To do so, we will use two different approaches.

B1) The Brennan and Schwartz algorithm or the projected UL

method

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Brennan and Schwartz introduced the algorithm for the American put option
problem in [2]. The solution algorithm is based on a Gaussian elimination where the
early exercise constraint of the option contract is handled in a simple manner. This
algorithm is analyzed in [3].

We define B=UL where U is an upper triangular matrix with UDD = 1 and L a lower
triangular matrix.

And then one has

min UgO e, O 4 = 0 min(gO U i6 e, O 4) = 0

Solution of the RHS is given by:

a) Solve j = U i6 e
b) Solve 789 gO j, O 4 = 0

With this method, we get 789 dO e, O 4 = 0 only when we use <6 instead
of <( .

B2) Semi-smooth Newtons method

For that method, we use this algorithm:

O \ given,
O kS6 = O k l(n k )i6 /l(O k )
With
dD,M , 8p (dO k e)D (O k 4)D
l(O)D,M =
VD,M , q1s+t8's

This method is better than the first one since there is no error whether we use <6
or <(

C) Splitting scheme

The method is characterized by two steps:

u vw%,(%) iu v
i) Compute U ES6 such that + ;U ES6,(6) + W 1ES6 = 0
x#
ii) Compute U ES6 = max (U ES6,(6)
, 4)

6
This method presents both positive and negative side. Indeed, this method has an
advantage in the sense that it can be applied to any case. But it not necessarily as
precise as the previous ones.

D)BDF2 implicit scheme

This new scheme is defined by:

3UMES6 4UME + {MEi6

789( + ;U ES6 + W 1ES6 )M , UMES6 4M = 0
2V1
And it is equivalent to

2 4 1 2
789 af + V1; U ES6 U E + U Ei6 + V1W 1ES6 , U ES6 4 = 0
3 3 3 3

The problem is still to solve for O | } , 789 dO e, O 4 = 0. We can use

Newtons method with:
(
d = af + V1;
~
 6 (
e = U U Ei6 V1W(1ES6 )
E
~ ~ ~

In that case, we need to know the two first terms in order to make the algorithm
work.

This scheme is (2,2) consistent but it is better than the CN scheme which is also
2nd order accurate in time and space. The higher the space step, the better the
results. Moreover, it converges more rapidly.

4 Numerical Experiments
In this section, we present numerical experiments with the methods discussed in
the previous sections. We show that in the option pricing the BDF2 formula is
more efficient time discretization than the widely used Crank-Nicolson method.

Two payoffs will be used for all tests and all the parameters will be same in order to
get significant comparisons. K = 100 , Smax = 200 , T = 1, ) = 0,2 , r = 0,1 , and
Smin = 0.

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Payoff 1 is defined by
<6 O ( O)S with ,F 1 = BCDE

Payoff 2 is given by

<( O = 2 , 8p O
2
0, q1s+t8's

With ,F 1 = 0.

As we cannot detail all the computations, in the sequel, we will only give the results
that have been requested in the td.

A) Explicit Euler scheme

For the Explicit Euler scheme, when I=N=20, one gets the following results: CFL
= 0.882, Stability is then satisfied. But in the case where I=20 and N=50, we do
not have stability as we can see it below on the graphs

Figure 1. Explicit Euler Scheme with I=N=20

8
Figure 2. Explicit Euler Scheme with I=50 and N=20

B) BDF2 Scheme

For the classical payoff, one gets the following picture:

Figure 3. BDF2 Implicit Scheme with J=N=79

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And the following results :

J N Error g6 Order Time(s)

79 79 0.01049 - 0.69
159 159 0.00112 3.23 0.72
319 319 0.00070 0.68 1.09
639 639 0.00066 0.08 9.31
1279 1279 0.00040 0.72 96.79

TABLE 1. BDF2-implicit Scheme with N=J

J N Error g6 Order Time(s)

79 7 0.06445 - 0.61
159 15 0.03483 0.8878 1.50
319 319 0.01808 0.94 0.89
639 63 0.00918 4.2998 4.29
1279 127 0.00464 0.9843 51.29

TABLE 2. BDF2-implicit Scheme with NJ, and higher CFL number.

C) CN scheme

Here is what we have when we run the classical payoff

Figure 4.CN Scheme with J=N=79

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 J N Error g6 Order Time(s)

79 79 1.07905 - 1.00
159 159 1.06690 0.016 0.76
319 319 1.06387 0.0041 0.99
639 639 1.06311 0.0010 3.10
1279 1279 1.06292 0.0002 27.69

TABLE 3. Crank-Nicholson Scheme with N=J.

J N Error g6 Order Time(s)

79 7 1.01433 - 1.00
159 15 1.04314 -0.040 1.38
319 31 1.05381 -0.014 0.65
639 63 1.05850 -0.006 0.82
1279 127 1.06072 -0.003 3.19

TABLE 4. Crank-Nicholson Scheme with NJ, with higher CFL number.

D)Newtons scheme

With the classical payoff, one gets CFL : 5.202. If we take the barrier payoff, we
can also see that the method gives no error.

Figure 5. N=20, I=50 and with the classical payoff function <6

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 Figure 6.N=20, I=50 and with particular payoff function <(

5. Conclusions
In this paper, we have considered finite difference methods for pricing American
options. We have studied time discretization schemes for the Black-Scholes partial
differential equation and introduced a reformulation of the Brennan and Schwartz
algorithm.

We applied the BDF2 formula for the time discretization and in the numerical
experiments these were found out to be more accurate than the Crank-Nicolson
method. The discontinuous first derivative of the payoff function decreases
convergence rate. We demonstrated that the convergence rates of the L- stable BDF2
formula is better than the convergence rate of the Crank-Nicolson method.

As we have seen, determining an approximation of an American put option can be

computed by many different ways. To find the best one, we should take into account
of some factors such as the stability, the consistency and the convergence of the
method.

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Stability is satisfied by the Explicit Euler scheme but we can see that we can find
better approximation of our problem. EE is only (1,2)-consistent whereas the Crank
Nicholson scheme is (2,2)-consistent.

But the best scheme remains the BDF2 implicit scheme. Indeed, it is still (2,2)-
consistent and even with higher CFL, order is almost 2 so the convergence has been
improved compared to the CN scheme.

Acknowledgements
The authors would like to thank Prof. Olivier Bokanowski for useful insights and
helpful comments.

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