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Numerical Methods for Pricing American Options with Time-Fractional PDE Models

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  • Zhiqiang Zhou
  • Xuemei Gao

Abstract

In this paper we develop a Laplace transform method and a finite difference method for solving American option pricing problem when the change of the option price with time is considered as a fractal transmission system. In this scenario, the option price is governed by a time-fractional partial differential equation (PDE) with free boundary. The Laplace transform method is applied to the time-fractional PDE. It then leads to a nonlinear equation for the free boundary (i.e., optimal early exercise boundary) function in Laplace space. After numerically finding the solution of the nonlinear equation, the Laplace inversion is used to transform the approximate early exercise boundary into the time space. Finally the approximate price of the American option is obtained. A boundary-searching finite difference method is also proposed to solve the free-boundary time-fractional PDEs for pricing the American options. Numerical examples are carried out to compare the Laplace approach with the finite difference method and it is confirmed that the former approach is much faster than the latter one.

Suggested Citation

  • Zhiqiang Zhou & Xuemei Gao, 2016. "Numerical Methods for Pricing American Options with Time-Fractional PDE Models," Mathematical Problems in Engineering, Hindawi, vol. 2016, pages 1-8, February.
    • Handle: RePEc:hin:jnlmpe:5614950
    DOI: 10.1155/2016/5614950
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