Weak Galerkin finite element method for valuation of American options

Abstract

We introduce a weak Galerkin finite element method for the valuation of American options governed by the Black-Scholes equation. In order to implement, we need to solve the optimal exercise boundary and then introduce an artificial boundary to make the computational domain bounded. For the optimal exercise boundary, which satisfies a nonlinear Volterra integral equation, it is resolved by a higher-order collocation method based on graded meshes. With the computed optimal exercise boundary, the front-fixing technique is employed to transform the free boundary problem to a one-dimensional parabolic problem in a half infinite area. For the other spatial domain boundary, a perfectly matched layer is used to truncate the unbounded domain and carry out the computation. Finally, the resulting initial-boundary value problems are solved by weak Galerkin finite element method, and numerical examples are provided to illustrate the efficiency of the method.

Keywords

American option / optimal exercise boundary / weak Galerkin finite element method

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Higher Education Press and Springer-Verlag Berlin Heidelberg