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    A Robust Numerical Scheme for Pricing American Options Under Regime Switching Based on Penalty Method

    Access Status
    Fulltext not available
    Authors
    Zhang, Kai
    Teo, Kok Lay
    Swartz, Mick
    Date
    2013
    Type
    Journal Article
    
    Metadata
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    Citation
    Zhang, K and Teo, K L and Swartz, M. 2013. A Robust Numerical Scheme for Pricing American Options Under Regime Switching Based on Penalty Method. Computational Economics. 43: pp. 463-483.
    Source Title
    Computational Economics
    DOI
    10.1007/s10614-013-9361-3
    ISSN
    0927-7099
    URI
    http://hdl.handle.net/20.500.11937/42188
    Collection
    • Curtin Research Publications
    Abstract

    This paper is devoted to develop a robust numerical method to solve a system of complementarity problems (CPs) arising from pricing American options under regime switching. Based on a penalty method, the system of complementarity problems are approximated by a set of coupled nonlinear partial differential equations (PDEs). We then introduce a fitted finite volume (FFVM) method for the spatial discretization along with a fully implicit time stepping scheme for the PDEs, which results in a system of nonlinear algebraic equations. We show that this scheme is consistent, stable and monotone, hence convergent. To solve the system of nonlinear equations effectively, an iterative solution method is established. The convergence of the solution method is shown. Numerical tests are performed to examine the convergence rate and verify the effectiveness and robustness of the new numerical scheme.

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