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A Proof of the Smoothness of the Finite Time Horizon American Put Option for Jump Diffusions

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  • Erhan Bayraktar

Abstract

We give a new proof of the fact that the value function of the finite time horizon American put option for a jump diffusion, when the jumps are from a compound Poisson process, is the classical solution of a free boundary equation. We also show that the value function is $C^1$ across the optimal stopping boundary. Our proof, which only uses the classical theory of parabolic partial differential equations of [7,8], is an alternative to the proof that uses the the theory of vicosity solutions [14]. This new proof relies on constructing a monotonous sequence of functions, each of which is a value function of an optimal stopping problem for a geometric Brownian motion, converging to the value function uniformly and exponentially fast. This sequence is constructed by iterating a functional operator that maps a certain class of convex functions to classical solutions of corresponding free boundary equations. On the other handsince the approximating sequence converges to the value function exponentially fast, it naturally leads to a good numerical scheme. We also show that the assumption that [14] makes on the parameters of the problem, in order to guarantee that the value function is the \emph{unique} classical solution of the corresponding free boundary equation, can be dropped.

Suggested Citation

  • Erhan Bayraktar, 2007. "A Proof of the Smoothness of the Finite Time Horizon American Put Option for Jump Diffusions," Papers math/0703782, arXiv.org, revised Dec 2008.
  • Handle: RePEc:arx:papers:math/0703782
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    References listed on IDEAS

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    1. Carr, Peter, 1998. "Randomization and the American Put," The Review of Financial Studies, Society for Financial Studies, vol. 11(3), pages 597-626.
    2. Luis H. R. Alvarez, 2001. "Solving optimal stopping problems of linear diffusions by applying convolution approximations," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 53(1), pages 89-99, April.
    3. L. Alili & A. E. Kyprianou, 2005. "Some remarks on first passage of Levy processes, the American put and pasting principles," Papers math/0508487, arXiv.org.
    4. Wilmott,Paul & Howison,Sam & Dewynne,Jeff, 1995. "The Mathematics of Financial Derivatives," Cambridge Books, Cambridge University Press, number 9780521497893, October.
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    Cited by:

    1. Erhan Bayraktar & Hao Xing, 2009. "Pricing American options for jump diffusions by iterating optimal stopping problems for diffusions," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 70(3), pages 505-525, December.
    2. Juozas Vaicenavicius, 2017. "Asset liquidation under drift uncertainty and regime-switching volatility," Papers 1701.08579, arXiv.org, revised Jan 2019.
    3. Erhan Bayraktar & Zhou Zhou, 2012. "On controller-stopper problems with jumps and their applications to indifference pricing of American options," Papers 1212.4894, arXiv.org, revised Nov 2013.

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