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Method of lines for valuation and sensitivities of Bermudan options

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  • Purba Banerjee
  • Vasudeva Murthy
  • Shashi Jain

Abstract

In this paper, we present a computationally efficient technique based on the \emph{Method of Lines} (MOL) for the approximation of the Bermudan option values via the associated partial differential equations (PDEs). The MOL converts the Black Scholes PDE to a system of ordinary differential equations (ODEs). The solution of the system of ODEs so obtained only requires spatial discretization and avoids discretization in time. Additionally, the exact solution of the ODEs can be obtained efficiently using the exponential matrix operation, making the method computationally attractive and straightforward to implement. An essential advantage of the proposed approach is that the associated Greeks can be computed with minimal additional computations. We illustrate, through numerical experiments, the efficacy of the proposed method in pricing and computation of the sensitivities for a European call, cash-or-nothing, powered option, and Bermudan put option.

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  • Purba Banerjee & Vasudeva Murthy & Shashi Jain, 2021. "Method of lines for valuation and sensitivities of Bermudan options," Papers 2112.01287, arXiv.org.
    • Handle: RePEc:arx:papers:2112.01287
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    References listed on IDEAS

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