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An iterative splitting method for pricing European options under the Heston model☆

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  • Li, Hongshan
  • Huang, Zhongyi

Abstract

In this paper, we propose an iterative splitting method to solve the partial differential equation (PDE) in option pricing problems. We focus on the Heston stochastic volatility model and the derived two-dimensional PDE. We take the European option as an example and conduct numerical experiments using different boundary conditions. The iterative splitting method transforms the two-dimensional equation into two quasi one-dimensional equations with the variable on the other dimension fixed, which helps to lower the computational cost. Numerical results show that the iterative splitting method together with an artificial boundary condition (ABC) based on the method by Li and Huang (2019) gives the most accurate option price and Greeks compared to the classic finite difference method with the commonly-used boundary conditions in Heston (1993).

Suggested Citation

  • Li, Hongshan & Huang, Zhongyi, 2020. "An iterative splitting method for pricing European options under the Heston model☆," Applied Mathematics and Computation, Elsevier, vol. 387(C).
    • Handle: RePEc:eee:apmaco:v:387:y:2020:i:c:s0096300320303854
    DOI: 10.1016/j.amc.2020.125424
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