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An iterative algorithm for evaluating approximations to the optimal exercise boundary for a nonlinear Black-Scholes equation

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  • Daniel Sevcovic

Abstract

The purpose of this paper is to analyze and compute the early exercise boundary for a class of nonlinear Black--Scholes equations with a nonlinear volatility which can be a function of the second derivative of the option price itself. A motivation for studying the nonlinear Black--Scholes equation with a nonlinear volatility arises from option pricing models taking into account e.g. nontrivial transaction costs, investor's preferences, feedback and illiquid markets effects and risk from a volatile (unprotected) portfolio. We present a new method how to transform the free boundary problem for the early exercise boundary position into a solution of a time depending nonlinear parabolic equation defined on a fixed domain. We furthermore propose an iterative numerical scheme that can be used to find an approximation of the free boundary. We present results of numerical approximation of the early exercise boundary for various types of nonlinear Black--Scholes equations and we discuss dependence of the free boundary on various model parameters.

Suggested Citation

  • Daniel Sevcovic, 2007. "An iterative algorithm for evaluating approximations to the optimal exercise boundary for a nonlinear Black-Scholes equation," Papers 0710.5301, arXiv.org.
    • Handle: RePEc:arx:papers:0710.5301
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    References listed on IDEAS

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    Cited by:

    1. Zhongkai Liu & Tao Pang, 2016. "An efficient grid lattice algorithm for pricing American-style options," International Journal of Financial Markets and Derivatives, Inderscience Enterprises Ltd, vol. 5(1), pages 36-55.
    2. Tomas Bokes & Daniel Sevcovic, 2009. "Early exercise boundary for American type of floating strike Asian option and its numerical approximation," Papers 0912.1321, arXiv.org.
    3. Chinonso Nwankwo & Weizhong Dai, 2020. "Explicit RKF-Compact Scheme for Pricing Regime Switching American Options with Varying Time Step," Papers 2012.09820, arXiv.org, revised Feb 2022.
    4. Chinonso I. Nwankwo & Weizhong Dai & Ruihua Liu, 2023. "Compact Finite Difference Scheme with Hermite Interpolation for Pricing American Put Options Based on Regime Switching Model," Computational Economics, Springer;Society for Computational Economics, vol. 62(3), pages 817-854, October.

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