Finite-Dierence Method: Theta-Scheme

Artur Sepp Mail: artursepp@hotmail.com, Web: www.hot.ee/seppar 30 August 2002

Abstract
In this project we present nite dierence methodologies (FD) to solve a one-dimensional parabolic partial derivation equation (PDE). This presentation is intended mainly for pedagogical purposes. We present only the core: equations needed for coding a FD solver and some guidance.

Contents
1 Finite-Dierence Discretization 2 Boundary conditions 2.1 Dirichlet boundary conditions . . . . . . . . . . . . . . . . . . 2.2 Neumann boundary conditions . . . . . . . . . . . . . . . . . . 2.3 Mixed boundary conditions . . . . . . . . . . . . . . . . . . . 3 Solving Matrix Equation 4 Interpolation 5 Free Boundary Problem 6 Implementation Strategy 7 Conclusions Bibliography 1 3 3 4 4 4 4 5 5 5 6

Finite-Dierence Discretization

We consider a general form of the one-dimensional parabolic equation (PDE) given by: V (x, t) 2 V (x, t) V (x, t) = a(x, t) + b(x, t) + c(x, t)V (x, t) + f (x, t) (1.1) t x2 x 1

subject to the initial condition V (x, 0) = g(x) (1.2)

We approximate PDE (1.1) in the bounded domain [xmin , xmax ][tmin , tmax ]. Let us denote Lh Vik := bk ak i k k k k Vi+1 2Vik + Vi1 + i Vi+1 Vi1 + ck Vik , i 2 h 2h (1.3)

t where l = tmaxm min ja h = xmax xmin . n Weighted FD scheme or theta-scheme is given by

(Vik+1 Vik ) = Lh Vik+1 + (1 )Lh Vik + fik+1 + (1 )fik . l We note that if = 0 we get the explicit nite-dierence scheme, = 0.5 we get the Crank-Nicolson implicit nite-dierence scheme, = 1 we get the fully implicit nite-dierence scheme.

(1.4)

When = 0.5 the method error is O(h2 , l2 ). Otherwise, the method error is O(h2 , l). The explicit method has disadvantage of certain stability conditions. The implicit methods are absolutely stable. Applying Lh for PDE (1.1), we get Vik+1 Vik = lak+1 (1 )lak i i k+1 k+1 k k Vi+1 2Vik+1 + Vi1 + Vi+1 2Vik + Vi1 + h2 h2 lbk+1 (1 )lbk i i k+1 k+1 k k + Vi+1 Vi1 + Vi+1 Vi1 + lck+1 Vik+1 + (1 )lck Vik + i i 2h 2h k+1 k + lfi + (1 )lfi . (1.5) Simplifying, we obtain a general form of theta-scheme discretization lak+1 lbk+1 2lak+1 lak+1 lbk+1 i i i i k+1 + Vi1 + 1 + lck+1 Vik+1 + i2 i h2 2h h2 h 2h (1 )lak (1 )lbk 2(1 )lak i i i k = Vi1 + 1 + (1 )lck Vik i 2 2 h 2h h (1 )lak (1 )lbk i i k + + Vi+1 + lfik+1 + (1 )lfik . h2 2h (1.6) 2
k+1 Vi+1

We introduce lak lbk i i, h2 2h k 2la Bik = 2i + lck , i h k k lb lai Cik = 2 + i , h 2h k Ri = (lfik+1 + (1 )lfik ). Ak = i Substituting these into (1.6), we get
k+1 k+1 Ak+1 Vi1 + (1 Bik+1 )Vik+1 Cik+1 Vi+1 i k k k = (1 )Ak Vi1 + (1 + (1 )Bik )Vik + (1 )Cik Vi+1 + Ri , i

(1.7)

(1.8)

i = 0, . . . , N. Thus we have N 1 equations with N + 1 unknowns. Two equations come from boundary conditions.

Boundary conditions

Boundary condition play an important role in FD discretization. We consider three most typical conditions.

2.1

Dirichlet boundary conditions

k k We assume that V0k ja VN are given: V0k = 1 (tk ) and VN = 2 (tk ). The algorithm is as follows

[i = 0] V0k+1 = 1 (tk+1 )
k+1 k+1 k k [i = 1] (1 B1 )V1k+1 C1 V2k+1 = (1 + (1 )B1 )V1k + (1 )C1 V2k k + Ak+1 V0k+1 + (1 )Ak V0k + R1 1 1 [i = 2, ..., N 2] equation (1.8) k+1 k+1 k+1 [i = N 1] Ak+1 VN 2 + (1 BN 1 )VN 1 N 1 k+1 k+1 k k k k k k = (1 )Ak 1 VN 2 + (1 + (1 )BN 1 )VN 1 + CN 1 VN + (1 )CN 1 VN + RN 1 N k [i = N ] VN = 2 (tk )

2.2

Neumann boundary conditions

k k We assume that V0k = 1 + 1 V1k and VN = 2 + 2 VN 1 . The algorithm is as follows

[i = 0] V0k+1 = 1 + 1 V1k+1
k+1 k+1 [i = 1] (1 Ak+1 + 1 B1 )V1k+1 C1 V2k+1 1 k k k = ((1 )1 Ak + 1 + (1 )B1 )V1k + (1 )C1 V2k+1 + (R1 + 1 Ak+1 + (1 )1 Ak ) 1 1 1 [i = 2, ..., N 2] equation (1.8) k+1 k+1 k+1 k+1 [i = N 1] Ak+1 VN 1 + (1 BN 1 2 CN 1 )VN 1 N 1 k k k k = (1 )Ak 1 VN 2 + (1 + (1 )BN 1 + (1 )2 CN 1 )VN 1 N k+1 k k + (RN 1 + 2 CN 1 + (1 )2 CN 1 ) k k [i = N ] VN = 2 + 2 VN 1

2.3

Mixed boundary conditions

2

We assume that V = 0. It follows that x2 k k k V0k = 2V1k V2k and VN = 2VN 1 VN 2 . The algorithm is as follows [i = 0] V0k+1 = 2V1k+1 V2k+1
k+1 k+1 [i = 1] (2Ak+1 + 1 B1 )V1k+1 + (Ak+1 C1 )V2k+1 1 1 k k k = (2(1 )Ak + 1 + (1 )B1 )V1k + ((1 )Ak + (1 )C1 )V2k + R1 1 1 [i = 2, ..., N 2] equation (1.8) k+1 k+1 k+1 k+1 k+1 [i = N 1] (Ak+1 + CN 1 )VN 2 + (1 BN 1 2CN 1 )VN 1 N 1 k k k k k k = ((1 )Ak 1 (1 )CN 1 )VN 2 + (1 + (1 )BN 1 + 2(1 )CN 1 )VN 1 + RN 1 N k k k [i = N ] VN = 2VN 1 VN 2

Solving Matrix Equation

When > 0, we have to solve the matrix equation. The matrix has the tridiagonal form, which makes it possible to use explicit expressions for solving it. Another way is the Successive Over-Relaxation method (SOR).

Interpolation

In general, the point x0 , which we are interested in, is located in the solution domain [xmin , xmax ] somewhere between nodes xk1 and xk . This means that 4

we have to use interpolation. Two possible choices are piecewise linear and cubic spline interpolation.

Free Boundary Problem

One of the examples of the free boundary value problem is an American option: we must solve a PDE with an unknown boundary. At every time step, we must update the Vik with Vik := max Vik , payo(xi , k) , i = 1, ..., N 1. (5.1)

Implementation Strategy

To code the Finite-Dierence Solver in C++, we use the advances of the object oriented programming: classes and inheritance. We code two base (abstract) classes: one for solving PDE-s with constant coecients and another for PDE-s with time-dependent coecients. In each class, there are dened several pure virtual functions (they have to be specied by the derived class): ones return the values of coecients a(x, t), b(x, t), and c(x, t) for given values of x and t; others return initial values and option payos. Derive classes specify the space variable x (for example, a stock price or interest rate), xmin , xmax , h = dx, and so on as well as the functional form of coecients, initial condition and payos.

Conclusions

FD is a powerful methods for solving PDEs. It is worthwhile implementing in the presence of time-dependent coecients and boundary value problems. We used our implemented FD solvers for a number of PDE-s arising in mathematical nance: 1) the Black-Scholes PDE, 2) the Black-Scholes PDE with discrete dividends, 3) the Black-Scholes PDE for barrier options, 4) PDEs for the equilibrium term structure models (CIR, Vasicek), 5) the Hull-White PDE with a time-dependent long-term mean, 6) the PDE with a local volatility function for vanilla and barrier options. We compared numerical solutions with some known analytical formulas and found that the FD discretization leads to reliable and accurate results. 5

By presenting and coding the nite-dierence methodologies, we found the following sources to be especially useful.

References
[1] Flannery B, Press W, Teukolsky S and Vetterling W, (1992), Numerical recipes in C: The Art of Scientic Computing, Cambridge University Press. [2] Thomas W, (1995), Numerical partial dierential equations: nite difference methods, New York. [3] Wilmott W, (2000), Paul Wilmott on Quantitative Finance, John Wiley and Sons.