DOCSLIB.ORG

Real Rainbow Options in Commodity Applications Valuing Multi-Factor Output Options Under Uncertainty

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Real Rainbow Options in Commodity Applications Valuing Multi-Factor Output Options Under Uncertainty Real Rainbow Options in Commodity Applications Valuing Multi-Factor Output Options under Uncertainty A Thesis submitted to the University of Manchester for the Degree of Doctor of Business Administration in the Faculty of Humanities 2010 Jörg Dockendorf Manchester Business School Contents LIST OF TABLES ....................................................................................................... 4 LIST OF FIGURES ..................................................................................................... 4 ABSTRACT .................................................................................................................. 5 DECLARATION .......................................................................................................... 6 COPYRIGHT STATEMENT ..................................................................................... 7 ACKNOWLEDGEMENTS ......................................................................................... 8 1 INTRODUCTION ................................................................................................ 9 1.1 Research Objectives and Questions ............................................................. 11 1.2 Contributions to Knowledge ........................................................................ 12 1.3 Thesis Overview........................................................................................... 13 2 REVIEW OF RAINBOW OPTIONS AND THE COMMODITY CONTEXT .................................................................................................................. 18 2.1 Rainbow Options .......................................................................................... 18 2.2 Stochastic Processes for Commodity Prices ................................................ 27 2.3 Overview of Solution Techniques ................................................................ 32 3 RESEARCH PAPER #1 – CONTINUOUS RAINBOW OPTIONS ON COMMODITY OUTPUTS: WHAT IS THE REAL VALUE OF SWITCHING FACILITIES? ............................................................................................................. 39 4 RESEARCH PAPER #2 – CONTINUOUS RAINBOW OPTIONS IN CO- INTEGRATED MARKETS ...................................................................................... 91 5 RESEARCH PAPER #3 – SEQUENTIAL REAL RAINBOW OPTIONS 144 6 CONCLUSION ................................................................................................. 196 6.1 Findings ...................................................................................................... 196 6.2 Critical Discussion ..................................................................................... 199 6.2.1 Problem framing .............................................................................................. 199 6.2.2 Critical Assumptions ........................................................................................ 201 6.2.3 Theory .............................................................................................................. 202 6.2.4 Numerical solution methods ............................................................................. 204 6.3 Directions of Future Research .................................................................... 205 – 2 – REFERENCES ......................................................................................................... 207 APPENDIX A.1. IMPLEMENTATION OF NUMERICAL LATTICE SOLUTION ............................................................................................................... 214 APPENDIX A.2. IMPLEMENTATION OF FINITE DIFFERENCE SOLUTION FOR SEQUENTIAL RAINBOW OPTION ON TWO ASSETS ......................... 219 APPENDIX A.3. IMPLEMENTATION OF FINITE DIFFERENCE SOLUTION FOR SEQUENTIAL RAINBOW OPTION ON MEAN-REVERTING ASSET .................................................................................................................................... 233 APPENDIX A.4. IMPLEMENTATION OF MONTE CARLO SIMULATION FOR SEQUENTIAL RAINBOW OPTION ON TWO ASSETS ......................... 243 APPENDIX A.5. IMPLEMENTATION OF MONTE CARLO SIMULATION FOR SEQUENTIAL RAINBOW OPTION ON MEAN-REVERTING ASSET .................................................................................................................................... 246 Word count: 45,221 – 3 – List of Tables Table 1. Overview of the Rainbow Option Models developed in this Thesis 10 Table 2. Characteristics of the Rainbow Option Models 15 Table 3. Literature Overview on Rainbow Options 23 Table 4. Comparison of Numerical Solution Methods 38 List of Figures Figure 1. The Rainbow Option Models on a Timeline 13 – 4 – Abstract Name of the University: The University of Manchester Candidate: Jörg Dockendorf Degree Title: Doctor of Business Administration Thesis Title: Real Rainbow Options in Commodity Applications: Valuing Multi-Factor Output Options under Uncertainty Date: 2010 This thesis focuses on the valuation of real options when there is flexibility given by the choice between two risky outputs. We develop models to value these rainbow options and to determine optimal operating and investment policies. These models are studied in the context of commodity applications because output flexibility is particularly relevant in volatile commodity markets. We provide insights into the behaviour and sensitivities of option values and operating policies and discuss implications for decision-making. In the early stages of real options theory, research centred on basic options with closed-form solutions, modelling single uncertainty in most cases. The challenge is now to incorporate more complexities in the models in order to further bridge the gap between theoretical models and reality, thereby promoting the widespread application of real options theory in corporate finance. The new option models developed in this thesis are organised in three self- contained research papers to address specific research problems. The first research paper studies an asset with flexibility to continuously choose the best of two risky commodity outputs by switching between them. We develop quasi-analytical and numerical lattice solutions for this real option model, taking into account operating and switching costs. An empirical application to a flexible fertilizer plant shows that the value of flexibility between the two outputs, ammonia and urea, exceeds the required additional investment cost (given the parameter values) despite the high correlation between the commodities. Implications are derived for investors and policy makers. The real asset value is mainly driven by non-stationary commodity prices in combination with constant operating costs. In the second research paper, we study an asset with flexibility to continuously choose the best of two co-integrated commodities. The uncertainty in two commodity prices is reduced to only one source of uncertainty by modelling the spread, which is mean-reverting in the case of co- integration. Our quasi-analytical solution distinguishes between different risk and discount factors which are shown to be particularly relevant in the context of mean- reversion. In an empirical application, a polyethylene plant is valued and it is found that the value of flexibility is reduced by strong mean-reversion in the spread between the commodities. Hence, operating flexibility is higher when the commodities are less co-integrated. In the third research paper, we develop real option models to value European sequential rainbow options, first on the best of two correlated stochastic assets and then on the spread between two stochastic co-integrated assets. We present finite difference and Monte Carlo simulation results for both, and additionally a closed-form solution for the latter. Interestingly, the sequential option value is negatively correlated with the volatility of one of the two assets in the special case when the volatility of that asset is low and the option is in-the-money. Also, the sequential option on the mean-reverting spread does not necessarily increase in value with a longer time to maturity. – 5 – Declaration No portion of the work referred to in the thesis has been submitted in support of an application for another degree or qualification of this or any other university or other institute of learning. – 6 – Copyright Statement i. The author of this thesis (including any appendices and/or schedules to this thesis) owns certain copyright or related rights in it (the “Copyright”) and s/he has given The University of Manchester certain rights to use such Copyright, including for administrative purposes. ii. Copies of this thesis, either in full or in extracts and whether in hard or electronic copy, may be made only in accordance with the Copyright, Designs and Patents Act 1988 (as amended) and regulations issued under it or, where appropriate, in accordance with licensing agreements which the University has from time to time. This page must form part of any such copies made. iii. The ownership of certain Copyright, patents, designs, trademarks and other intellectual property (the “Intellectual Property”) and any reproductions of copyright works in the thesis, for example graphs and tables (“Reproductions”), which may be described in this thesis, may not be owned by the author and may be owned by third parties. Such Intellectual Property and Reproductions cannot and must not be made available for use without the prior written permission of the owner(s) of the relevant Intellectual
Load more

Recommended publications
  • The Promise and Peril of Real Options
    1 The Promise and Peril of Real Options Aswath Damodaran Stern School of Business 44 West Fourth Street New York, NY 10012 [email protected] 2 Abstract In recent years, practitioners and academics have made the argument that traditional discounted cash flow models do a poor job of capturing the value of the options embedded in many corporate actions. They have noted that these options need to be not only considered explicitly and valued, but also that the value of these options can be substantial. In fact, many investments and acquisitions that would not be justifiable otherwise will be value enhancing, if the options embedded in them are considered. In this paper, we examine the merits of this argument. While it is certainly true that there are options embedded in many actions, we consider the conditions that have to be met for these options to have value. We also develop a series of applied examples, where we attempt to value these options and consider the effect on investment, financing and valuation decisions. 3 In finance, the discounted cash flow model operates as the basic framework for most analysis. In investment analysis, for instance, the conventional view is that the net present value of a project is the measure of the value that it will add to the firm taking it. Thus, investing in a positive (negative) net present value project will increase (decrease) value. In capital structure decisions, a financing mix that minimizes the cost of capital, without impairing operating cash flows, increases firm value and is therefore viewed as the optimal mix.
    [Show full text]
  • Options Trading Strategies: Complete Guide to Getting Started and Making Money with Stock Options
    Options Trading Strategies Complete Guide to Getting Started and Making Money with Stock Options Scott J. Danes Dylanna Publishing Copyright © 2014 by Scott J. Danes All rights reserved. This book or any portion thereof may not be reproduced or used in any manner whatsoever without the express written permission of the publisher except for the use of brief quotations in a book review. Dylanna Publishing First edition: 2014 Disclaimer This book is for informational purposes only. The views expressed are those of the author alone, and should not be taken as expert, legal, or medical advice. The reader is responsible for his or her own actions. Every attempt has been made to verify the accuracy of the information in this publication. However, neither the author nor the publisher assumes any responsibility for errors, omissions, or contrary interpretation of the material contained herein. Neither the author or the publisher assumes any responsibility or liability whatsoever on the behalf of the reader or purchaser of this material. Contents Introduction Options 101 What Are Options? Buying and Selling Options Advantages of Options Trading Leverage Risk Limitation—Hedging Disadvantages of Options Trading Levels of Risk Intrinsic Value Time Decay Taxes Types and Styles of Options Call Options Put Options Using Call and Put Options to Make a Profit Styles of Options American Options European Options Exotic Options LEAPS Index Options Option Prices and Valuation In-The-Money (ITM) At-The-Money (ATM) Out-of-The-Money (OTM) Intrinsic Value versus
    [Show full text]
  • Analytical Finance Volume I
    The Mathematics of Equity Derivatives, Markets, Risk and Valuation ANALYTICAL FINANCE VOLUME I JAN R. M. RÖMAN Analytical Finance: Volume I Jan R. M. Röman Analytical Finance: Volume I The Mathematics of Equity Derivatives, Markets, Risk and Valuation Jan R. M. Röman Västerås, Sweden ISBN 978-3-319-34026-5 ISBN 978-3-319-34027-2 (eBook) DOI 10.1007/978-3-319-34027-2 Library of Congress Control Number: 2016956452 © The Editor(s) (if applicable) and The Author(s) 2017 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. Cover image © David Tipling Photo Library / Alamy Printed on acid-free paper This Palgrave Macmillan imprint is published by Springer Nature The registered company is Springer International Publishing AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland To my soulmate, supporter and love – Jing Fang Preface This book is based upon lecture notes, used and developed for the course Analytical Finance I at Mälardalen University in Sweden.
    [Show full text]
  • Radial Basis Function Methods for Pricing Multi-Asset Options
    IT Licentiate theses 2016-001 Radial Basis Function Methods for Pricing Multi-Asset Options VICTOR SHCHERBAKOV UPPSALA UNIVERSITY Department of Information Technology Radial Basis Function Methods for Pricing Multi-Asset Options Victor Shcherbakov [email protected] January 2016 Division of Scientific Computing Department of Information Technology Uppsala University Box 337 SE-751 05 Uppsala Sweden http://www.it.uu.se/ Dissertation for the degree of Licentiate of Philosophy in Scientific Computing with specialization in Numerical Analysis c Victor Shcherbakov 2016 ISSN 1404-5117 Printed by the Department of Information Technology, Uppsala University, Sweden Abstract The price of an option can under some assumptions be determ- ined by the solution of the Black{Scholes partial differential equation. Often options are issued on more than one asset. In this case it turns out that the option price is governed by the multi-dimensional version of the Black{Scholes equation. Op- tions issued on a large number of underlying assets, such as in- dex options, are of particular interest, but pricing such options is a challenge due to the \curse of dimensionality". The multi- dimensional PDE turn out to be computationally expensive to solve accurately even in quite a low number of dimensions. In this thesis we develop a radial basis function partition of unity method for pricing multi-asset options up to moderately high dimensions. Our approach requires the use of a lower number of node points per dimension than other standard PDE methods, such as finite differences or finite elements, thanks to a high or- der convergence rate. Our method shows good results for both European style options and American style options, which allow early exercise.
    [Show full text]
  • Making the Best of Best-Of Tristan Guillaume
    Making the best of best-of Tristan Guillaume To cite this version: Tristan Guillaume. Making the best of best-of. Review of Derivatives Research, Springer Verlag, 2008, 11, pp.1-39. hal-00924256 HAL Id: hal-00924256 https://hal.archives-ouvertes.fr/hal-00924256 Submitted on 6 Jan 2014 HAL is a multi-disciplinary open access L’archive ouverte pluridisciplinaire HAL, est archive for the deposit and dissemination of sci- destinée au dépôt et à la diffusion de documents entific research documents, whether they are pub- scientifiques de niveau recherche, publiés ou non, lished or not. The documents may come from émanant des établissements d’enseignement et de teaching and research institutions in France or recherche français ou étrangers, des laboratoires abroad, or from public or private research centers. publics ou privés. MAKING THE BEST OF BEST-OF published in Review of Derivatives Research, 2008, (11):1-39 Tristan Guillaume Université de Cergy-Pontoise, Laboratoire Thema 33 boulevard du port, 95011 Cergy-Pontoise Cedex, France [email protected] Tel. : + 33 6 12 22 45 88 Fax:+33134256233 1 Abstract This paper extends the analytical valuation of options on the maximum or the minimum of several risky assets in several directions. The first extension consists in including more assets in the payoff and making the latter more flexible by adding knock-in and knock-out provisions. The second extension consists in pricing these contracts in a multivariate jump-diffusion framework allowing for a stochastic two-factor term structure of interest rates. In both cases, explicit formulae are provided which yield prices quasi instantaneously and with utmost precision.
    [Show full text]
  • E Cient Computation of Option Price Sensitivities Using Homogeneity
    Ecient Computation of Option Price Sensitivities Using Homogeneity and other Tricks Oliver Rei Weierstra-Institute for Applied Analysis and Sto chastics Mohrenstrasse 39 10117 Berlin GERMANY [email protected] Uwe Wystup Commerzbank Treasury and Financial Pro ducts Neue Mainzer Strasse 32{36 60261 Frankfurt am Main GERMANY [email protected] http://www.mathfinance.de Preliminary version, January 25, 1999 Abstract No front-oce software can survive without providing derivatives of options prices with resp ect to underlying market or mo del parameters, the so called Greeks. We present a list of common Greeks and exploit homogeneity prop erties of nancial markets to derive relationships b etween Greeks out of which many are mo del- indep endent. We apply our results to Europ ean style options, rainbow options, path-dep endent options as well as options priced in Heston's sto chastic volatility mo del and show shortcuts to avoid exorbitant and time-consuming computations of derivatives whicheven strong symb olic calculators fail to pro duce. partially aliated to Delft University,by supp ort of NWO Netherlands 1 2 Rei, O. and Wystup, U. 1 Intro duction Based on homogeneity of time and price level of a nancial pro duct we can derive relations for the options sensitivities, the so-called \Greeks". The basic market mo del we use is the Black-Scholes mo del with sto cks paying a continuous dividend yield and a riskless cash b ond. This mo del supp orts the homogeneity prop erties which are valid in general, but its structure is so simple, that we can concentrate on the essential statements of this pap er.
    [Show full text]
  • ERIC C. CHANG Office Address Shanghai Advanced Institute Of
    ERIC C. CHANG Office Address Shanghai Advanced Institute of Finance Shanghai Jiaotong University Room 610, 211 West Huaihai Road Shanghai, P.R. China, 200030 Tel: 86-21-6293-2129 E-mail: [email protected] EDUCATION 1982 Ph.D. in Finance (Major) and in Statistics and Econometrics (Minor) Purdue University (West Lafayette, Indiana USA) 1979 MBA in Finance Wright State University (Dayton, Ohio USA) 1974 B.S. in Civil Engineering Cheng Kung University (Taiwan) ACADEMIC APPOINTMENTS 2018 – present Professor in Finance Shanghai Advanced Institute of Finance Shanghai Jiaotong University (Shanghai, China) 2007 – 2018 Chung Hon-Dak Professor in Finance Faculty of Business and Economics The University of Hong Kong (Hong Kong) 1998 – 2018 Chair Professor of Finance (tenured) School of Business / School of Economics and Finance Faculty of Business and Economics The University of Hong Kong (Hong Kong) 1995 – 1998 Invesco Chair Professor of International Finance (tenured) The DuPree College of Management Georgia Institute of Technology (Atlanta, Georgia, USA) 2003 – 2009 Visiting Professor Executive MBA Program Fudan University (Shanghai, PRC) 2005 – 2009 Visiting Professor Executive Education Program Shenzhen Graduate School of Business Peking University (Shenzhen, PRC) 30/06/2019 Page 1 1986 – 1995 Assistant, Associate and Professor in Finance (tenured) College of Business and Administration University of Maryland (College Park, Maryland, USA) 1992 – 1994 Reader (Visiting) in Finance School of Business and Management Hong Kong University of
    [Show full text]
  • Glossary of Financial Derivatives* Paul D. Koch [email protected]
    1 Glossary of Financial Derivatives* Paul D. Koch [email protected] University of Kansas 785-864-7503 Lawrence, KS 66045 *This document draws heavily from several sources: (a) Website of Don Chance, www.fbox.vt.edu/filebox/business/finance/dmc/DRU; (b) Hull, J.C., Fundamentals of Futures & Options Markets, 8th Edition, Prentice-Hall, Inc.: New York, NY, 2014; I. Background. Yield Curve – relation among interest rates paid on securities alike in every respect except maturity. (How interest rates change from short term to long term securities.) Eurodollar - dollar-denominated deposits outside the jurisdiction of the U.S. regulatory authorities. Financial Derivative - financial claim whose value is contingent upon movements in some underlying variable such as a stock or stock index, interest rates, exchange rates, or commodity prices; includes forwards, futures, options, SWAPs, asset-backed securities, structured notes (hybrid debt), & other combinations of these instruments. LIBOR - London Interbank Offer Rate; rate charged on short term Eurodollar deposits; benchmark floating rate for international borrowing/lending in $. Margin - good faith 'collateral' deposit, specified as a percentage of the value of the financial instrument in question; ensures integrity of market. Organized Exchange - centralized location where organized trading is conducted in certain financial instruments under a specific set of rules. The exchange clearinghouse is the counter-party to every transaction; members of the exchange share the responsibility of fulfilling commitments. The exchange: (i) sets standardized terms for all contracts traded, and (ii) often places restrictions on trading (e.g. margin requirements, limits on daily price changes, limits on size of individual positions, ...). Standardization of contracts and other rules make clearing easier, reduce uncertainty about counterparty default risk, and help ensure an orderly market.
    [Show full text]
  • Pricing and Hedging Multi-Asset Options (Incomplete Preliminary Version, Do Not Quote)
    PRICING AND HEDGING MULTI-ASSET OPTIONS (INCOMPLETE PRELIMINARY VERSION, DO NOT QUOTE) MIRET PADOVANI AND PAOLO VANINI Abstract. The aim of this paper is to investigate the implications of sto- chastic correlations when pricing and hedging structured products written on multiple assets. A wide range of multi-asset options have emerged in the last years: rainbows, Himalayas, quantos, and spreads, just to name a few. The trickiness in pricing and hedging these options mainly stems from the volatili- ties of and pairwise correlations among their underlyings. For our analysis and for the sake of practicality, we take the specific example of a three-color best-of call rainbow option. We look at different pricing models both with constant and stochastic variance-covariance structures; for the latter, we give special at- tention to the multi-dimensional Ornstein-Uhlenbeck process, which has only recently been introduced in the derivative pricing literature. We then proceed to calibrate each model to data, perform sensitivity analyses, and determine appropriate hedging strategies. The question we ultimately want to answer is whether the introduction of stochastic correlations can lead to a model which is both theoretically meaningful and practically usable. 1. Introduction The aim of this paper is to investigate the implications of stochastic correlations when pricing and hedging structured products written on multiple assets. We look at different pricing models both with constant and stochastic correlations. We then calibrate each model to data, perform sensitivity analyses, and determine appropriate hedging strategies. To our knowledge, such an extensive analysis on multi-asset products has not been carried out so far.
    [Show full text]
  • Evaluation the Price of Multi-Asset Rainbow Options Using Monte Carlo Method
    Journal of Applied Mathematics and Physics, 2016, 4, 178-182 Published Online January 2016 in SciRes. http://www.scirp.org/journal/jamp http://dx.doi.org/10.4236/jamp.2016.41021 Evaluation the Price of Multi-Asset Rainbow Options Using Monte Carlo Method A. Rasulov1, R. Rakhmatov1, A. Nafasov2 1University of World Economy and Diplomacy, Tashkent, Uzbekistan 2National University of Uzbekistan, Tashkent, Uzbekistan Received 21 October 2015; accepted 22 January 2016; published 29 January 2016 Abstract Solution of the system stochastic differential equations in multi dimensional case using Monte Carlo method had many useful features in compare with the other computational methods. One of them is the solution of boundary value problems to be found at just one point, if required (with associated saving in computation), whereas deterministic methods necessarily find the solution at large number of points simultaneously. This property can be particularly useful in problems such option pricing, where the value of an option is required only at the time of striking, and for the state of the market at that time. In this work we consider a European multi-asset options which mathematically described by the system of stochastic differential equations. We will apply Monte Carlo method for the solution of that system which is the price of Multi-asset rainbow options. Keywords Monte Carlo Method, Multi Asset Options, Boundary Value Problems, Stochastic Differential Equations 1. Introduction Monte Carlo simulation is a popular method for pricing financial options and other derivative securities because of the availability of powerful workstations and recent advances in applying the tool. The existence of easy-to-use software makes simulation accessible to many users who would otherwise avoid programming the algorithms necessary to value derivative securities.
    [Show full text]
  • Wiley Finance : Derivatives Demystified : a Step-By-Step Guide
    Derivatives Demystified For other titles in the Wiley Finance series please see www.wiley.com/finance Derivatives Demystified A Step-by-Step Guide to Forwards, Futures, Swaps and Options Second Edition Andrew M. Chisholm A John Wiley and Sons, Ltd., Publication This edition first published 2010 C 2010 John Wiley & Sons, Ltd Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com. The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered.
    [Show full text]
  • Numerical Methods for Pricing Multi-Asset Options by Yuwei Chen
    Numerical Methods for Pricing Multi-Asset Options by Yuwei Chen A thesis submitted in conformity with the requirements for the degree of Master of Science Graduate Department of Computer Science University of Toronto c Copyright 2017 by Yuwei Chen Abstract Numerical Methods for Pricing Multi-Asset Options Yuwei Chen Master of Science Graduate Department of Computer Science University of Toronto 2017 We consider the pricing of two-asset European and American options by numerical Partial Differential Equation (PDE) methods, and compare the results with certain analytical formulae. Two cases of options are tested: exchange option and spread option. For ex- change options, the analytical formula considered is the (exact) Margrabe formula. For spread options, we consider Kirk's formula and the formula by Li, Deng and Zhou. In pric- ing European two-asset options, the basic numerical PDE model is the two-dimensional Black-Scholes PDE. Different boundary conditions are considered, and the effect of them on the solution at various points of the grid is studied. Furthermore, various types of non-uniform grids are considered, aiming at reducing the error at certain areas of the grid. Moreover, the effect of the truncated domain on the PDE approximation is studied. We also discuss the effect of certain problem parameters, such as the length of maturity time, and the values of volatility and correlation, to the accuracy and convergence of the PDE approximations. The experiments indicate that the numerical PDE computed price and Greeks are second-order, for appropriately chosen grid discretizations. In the American pricing problem, the discrete penalty method is applied to the linear com- plementarity problem involving the two-dimensional Black-Scholes PDE and additional constraints.
    [Show full text]