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Convergence analysis of power penalty method for American bond option pricing

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  • K. Zhang
  • K. Teo

Abstract

This paper is concerned with the convergence analysis of power penalty method to pricing American options on discount bond, where the single factor Cox–Ingrosll–Ross model is adopted for the short interest rate. The valuation of American bond option is usually formulated as a partial differential complementarity problem. We first develop a power penalty method to solve this partial differential complementarity problem, which produces a nonlinear degenerated parabolic PDE. Within the framework of variational inequalities, the solvability and convergence properties of this penalty approach are explored in a proper infinite dimensional space. Moreover, a sharp rate of convergence of the power penalty method is obtained. Finally, we show that the power penalty approach is monotonically convergent with the penalty parameter. Copyright Springer Science+Business Media, LLC. 2013

Suggested Citation

  • K. Zhang & K. Teo, 2013. "Convergence analysis of power penalty method for American bond option pricing," Journal of Global Optimization, Springer, vol. 56(4), pages 1313-1323, August.
    • Handle: RePEc:spr:jglopt:v:56:y:2013:i:4:p:1313-1323
    DOI: 10.1007/s10898-012-9843-1
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    References listed on IDEAS

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    1. S. Wang & X. Q. Yang & K. L. Teo, 2006. "Power Penalty Method for a Linear Complementarity Problem Arising from American Option Valuation," Journal of Optimization Theory and Applications, Springer, vol. 129(2), pages 227-254, May.
    2. Brennan, Michael J & Schwartz, Eduardo S, 1977. "The Valuation of American Put Options," Journal of Finance, American Finance Association, vol. 32(2), pages 449-462, May.
    3. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 5, pages 129-164, World Scientific Publishing Co. Pte. Ltd..
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    Cited by:

    1. Zhe Sun & Zhe Liu & Xiaoqi Yang, 2015. "On power penalty methods for linear complementarity problems arising from American option pricing," Journal of Global Optimization, Springer, vol. 63(1), pages 165-180, September.
    2. Yarui Duan & Song Wang & Yuying Zhou, 2021. "A power penalty approach to a mixed quasilinear elliptic complementarity problem," Journal of Global Optimization, Springer, vol. 81(4), pages 901-918, December.

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