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The Fractional Step Method versus the Radial Basis Functions for Option Pricing with Correlated Stochastic Processes

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  • Yusho Kagraoka

    (Faculty of Economics, Musashi University, Tokyo 176-8534, Japan)

Abstract

In option pricing models with correlated stochastic processes, an option premium is commonly a solution to a partial differential equation (PDE) with mixed derivatives in more than two space dimensions. Alternating direction implicit (ADI) finite difference methods are popular for solving a PDE with more than two space dimensions; however, it is not straightforward to employ the ADI method for solving a PDE with mixed derivatives. The aim of this study is to find out which numerical method would be appropriate to solve PDEs with mixed derivatives based on the accuracy of the solutions and the computation time. This study applies the fractional step method and the radial basis functions to solve a PDE with a mixed derivative, and investigates the efficiency of these numerical methods. Numerical experiments are conducted by applying these methods to exchange option pricing; exchange options are selected because the exchange option premium has an analytical form. The numerical results show that the both methods calculate premiums with high accuracy in the presence of mixed derivatives. The fractional step method calculates the option premium more accurately and much faster than the radial basis functions. Therefore, from the numerical experiments, this study concludes that the fractional step method is more appropriate than the radial basis functions for solving a PDE with a mixed derivative.

Suggested Citation

  • Yusho Kagraoka, 2020. "The Fractional Step Method versus the Radial Basis Functions for Option Pricing with Correlated Stochastic Processes," IJFS, MDPI, vol. 8(4), pages 1-13, December.
    • Handle: RePEc:gam:jijfss:v:8:y:2020:i:4:p:77-:d:454494
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    References listed on IDEAS

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