On the Use of Policy Iteration as an Easy Way of Pricing American Options
AbstractIn this paper, we demonstrate that policy iteration, introduced in the context of HJB equations in [Forsyth & Labahn, 2007], is an extremely simple generic algorithm for solving linear complementarity problems resulting from the finite difference and finite element approximation of American options. We show that, in general, O(N) is an upper and lower bound on the number of iterations needed to solve a discrete LCP of size N. If embedded in a class of standard discretisations with M time steps, the overall complexity of American option pricing is indeed only O(N(M+N)), and, therefore, for M N, identical to the pricing of European options, which is O(MN). We also discuss the numerical properties and robustness with respect to model parameters in relation to penalty and projected relaxation methods.
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Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 1012.4976.
Date of creation: Dec 2010
Date of revision: Sep 2011
Publication status: Published in SIAM J. Finan. Math. 3(1), 459-478, 2012
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- Carl Chiarella & Boda Kang & Gunter H. Meyer & Andrew Ziogas, 2008.
"The Evaluation of American Option Prices Under Stochastic Volatility and Jump-Diffusion Dynamics Using the Method of Lines,"
Research Paper Series
219, Quantitative Finance Research Centre, University of Technology, Sydney.
- Carl Chiarella & Boda Kang & Gunter H. Meyer & Andrew Ziogas, 2009. "The Evaluation Of American Option Prices Under Stochastic Volatility And Jump-Diffusion Dynamics Using The Method Of Lines," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 12(03), pages 393-425.
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