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Valuation of the American put option as a free boundary problem through a high-order difference scheme

Murat Sari ORCID logo and Seda Gulen ORCID logo

Abstract

Valuation of the American options encountered commonly in finance is quite difficult due to the possibility of early exercise alternatives. Since an exact solution for the American options does not exist, effective numerical methods are needed to understand the behavior of option pricing models. Therefore, in this paper, a new approach based on a high-order difference scheme is proposed to discuss the valuation of an American put option as a free boundary problem. Using a front-fixing approach that transforms the unknown free boundary (optimal stopping) into a fixed one, a sixth-order finite difference scheme (FD6) in space and a third-order strong-stability preserving Runge–Kutta (SSPRK3) in time are applied to the model converted to a nonlinear partial differential equation. The computed results revealed that the combined method is seen to attempt to pull up the capacity of the algorithm to achieve higher accuracy. It is seen that the quantitative and qualitative results produced by the method proposed with minimal computational effort are sufficiently accurate and meaningful. Therefore, this article provides some new insights about the physical characteristics of financial problems and such realistic phenomena.

MSC 2010: 35Q91; 65M06

Corresponding author: Seda Gulen, Department of Mathematics, Faculty of Arts and Science, Tekirdag Namik Kemal University, Tekirdag, Turkey, E-mail:

  1. Author contribution: All the authors have accepted responsibility for the entire content of this submitted manuscript and approved submission.

  2. Research funding: None declared.

  3. Conflict of interest statement: The authors declare no conflicts of interest regarding this article.

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Received: 2020-03-01
Accepted: 2021-09-22
Published Online: 2021-11-29

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