《Numerical Valuation of European amer under Kou#39;s》.pdf

Numerical Valuation of European and American Options under Kou’s Jump-Diffusion Model∗ Jari Toivanen† Abstract Numerical methods are developed for pricing European and American op- tions under Kou’s jump-diffusion model which assumes the price of the un- derlying asset to behave like a geometrical Brownian motion with a drift and jumps whose size is log-double-exponentially distributed . The price of a Eu- ropean option is given by a partial integro-differential equation (PIDE) while American options lead to a linear complementarity problem (LCP) with the same operator. Spatial differential operators are discretized using finite differ- ences on nonuniform grids and time stepping is performed using the implicit Rannacher scheme. For the evaluation of the integral term easy to implement recursion formulas are derived which have optimal computational cost. When pricing European options the resulting dense linear systems are solved using a stationary iteration. For American options two ways to solve the LCPs are de- scribed: an operator slitting method and a penalty method. Numerical experi- ments confirm that the developed methods are very efficient as fairly accurate option prices can be computed in a few milliseconds on a PC. Keywords: option pricing, jump-diffusion model, partial integro-differential equa- tion, linear complementarity problem, finite difference method, operator splitting method, penalty method 1 Introduction The amount of financial option trading has grown to enormous scale since the pio- neering work by Black and Scholes [7] and Merton [33] on the pricing of options in 1973. During the last two decades it has become evident that their ass