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Model reduction for calibration of American options

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  • Olena Burkovska
  • Kathrin Glau
  • Mirco Mahlstedt
  • Barbara Wohlmuth

Abstract

American put options are among the most frequently traded single stock options, and their calibration is computationally challenging since no closed-form expression is available. Due to the higher flexibility in comparison to European options, the mathematical model involves additional constraints, and a variational inequality is obtained. We use the Heston stochastic volatility model to describe the price of a single stock option. In order to speed up the calibration process, we apply two model reduction strategies. Firstly, a reduced basis method (RBM) is used to define a suitable low-dimensional basis for the numerical approximation of the parameter-dependent partial differential equation ($\mu$PDE) model. By doing so the computational complexity for solving the $\mu$PDE is drastically reduced, and applications of standard minimization algorithms for the calibration are significantly faster than working with a high-dimensional finite element basis. Secondly, so-called de-Americanization strategies are applied. Here, the main idea is to reformulate the calibration problem for American options as a problem for European options and to exploit closed-form solutions. Both reduction techniques are systematically compared and tested for both synthetic and market data sets.

Suggested Citation

  • Olena Burkovska & Kathrin Glau & Mirco Mahlstedt & Barbara Wohlmuth, 2016. "Model reduction for calibration of American options," Papers 1611.06452, arXiv.org.
  • Handle: RePEc:arx:papers:1611.06452
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