University of Houston/Department of Mathematics Dr. Ronald H.W.

Hoppe Numerical Methods for Option Pricing in Finance

Chapter 6: Pricing of American Options

6.1 The Black-Scholes Inequality 6.1.1 American put option We know from Chapter 1 that the price PA of an American put option satises () PA(S, t) (K S)+ , 0tT . Since PA(0, t) = K = (K S)+|S=0 and PA(K, t) = 0, due to the continuity and monotonicity of PA there exists 0 SF(t) < K such that the payo is reached, i.e., PA(SF(t), t) = K SF(t) . Consequently, we have > (K S)+ , S > SF(t) PA(S, t) . = KS , 0 S SF(t)

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance
Stopping and Continuation Region
t

T Stopping region

S F (t) Continuation region

In the (S, t)-plane, the set {(SF(t), t) | 0 t T} denes a curve which partitions the semi-innite strip [0, ) [0, T] into two parts: The stopping region S := {(S, t) | S SF(t)} and the continuation region
S

S F (T)

C := {(S, t) | S > SF(t)}.

The economical meaning of the continuation and the stopping region is as follows: In the stopping region we have PA = K S and the put option should be exercised, since = K S + S = K can be invested at the risk-free interest rate r > 0. In the continuation region we have PA > (K S)+ and an early exercise of the option does not make sense.

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance
Freet boundary and stopping time
T Stopping region

Continuation region

S F (t) Free boundary S S F (T)

Since the curve (SF(t), t) | 0 t T} is an unknown of the problem, it is referred to as a free boundary. The time instant tS := min {0 t T | S = SF(t)} is called the stopping time.

At tS, the put option should be exercised, since holding it longer would reduce the prot of the risk-free investment.

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance
The determination of the free boundary requires an additional boundary condition besides PA PA(SF(t), t) = K SF(t). For that purpose we consider the slope S (SF(t), t) where PA(S, t) touches PA the straight line K S which obviously has the slope 1. We can rule out the case S (SF(t), t) < 1, because otherwise we would obtain a contradiction to (). Moreover, by an arbitrage arguPA ment it can be shown that the case S (SF(t), t) > 1 can be excluded as well. In other words, we obtain PA (SF(t), t) = 1 . S Hence, in case of an American put option with proportional dividend D0 > 0, the price PA(S, t) of the put option satises the free boundary problem PA(S, t) = K S PA 1 2 2 2PA PA + S rPA = 0 S > SF(t) : + ( r D ) S 0 t 2 S2 S with nal condition PA(S, T) = (K S)+ and boundary conditions PA(0, t) = K , lim PA(S, t) = 0 , PA(SF(t), t) = K SF(t) , ( PA/ S)(SF(t), t) = 1 .
S

S SF(t) :

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance

6.1.2 American call option As shown in Chapter 1, the price CA of an American call option is the same as the price CE of a European call option, if no dividends are paid. However, in case of a proportional dividend D0 > 0, for t < T and suciently large S we have 1) K exp(r(T t)) (d 2) = CE(S, t) , CA(S, t) (S K)+ = S K > S exp(D0(T t)) (d where 1/2 d
S ln( K ) + (r D0 2 )(T t) . = Tt
2

Since CA(K, t) = 0 and limS CA(S, t) = S K > 0, due to the continuity and monotonicity of CA there exists SF(t) > K such that the payo is reached, i.e., CA(SF(t), t) = SF(t) K , whence CA(S, t)

= SK , S SF(t) . > (S K)+ , 0 S < SF(t)

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance
Stopping and Continuation Region
t T Stopping region

S F (t) Continuation region

As in case of the put, the free boundary {(SF(t), t) | 0 t T} denes a continuation region C := {(S, t) | S SF(t)} , where it is advantageous to keep the option, and a stopping region S := {(S, t) | S > SF(t)} , where an early exercise makes sense.
S

S F (T)

The price CA of the call option satises the free boundary problem CA(S, t) = S K CA 1 2 2 2CA CA + S rCA = 0 + ( r D ) S S < SF(t) : 0 t 2 S2 S with nal condition CA(S, T) = (S K)+ and boundary conditions CA(0, t) = 0 , lim CA(S, t) = O(S) , CA(SF(t), t) = SF(t) K , ( CA/ S)(SF(t), t) = 1 .
S

S SF(t) :

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance

6.1.3 The Black-Scholes inequality for American options The free boundary problem for the price V = PA of an American put can be formulated as a Linear Complementarity Problem (LCP) which does not explicitly contain the free boundary. As in the derivation of the Black-Scholes equation, we assume a risk-free, self-nancing portfolio ()1 Y = c1 B + c2 S V . V As in Chapter 3, we deduce c2 = S and V 1 2 2 2V ()2 dY = (c1 r B ) dt . S t 2 S2 The owner of the portfolio has sold the put. If the buyer does not exercise it optimally, the seller can realize a higher prot than for a risk-free investment, i.e., dY rYdt. Inserting ()1 and ()2 into this inequality results in the so-called Black-Scholes inequality () 1 2 2 2V V V + S rV 0. + ( r D ) S 0 t 2 S2 S

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance
When does equality and when does strict inequality hold true in ()? Case I (S > SF(t)) : We already know from 6.1.1 that in this case the equality sign applies. Case I (S SF(t)) : We claim that in this case strict inequality holds true. The proof is easy for D0 = 0: Inserting PA = K S into the Black-Scholes equation yields PA PA 1 2 2 2PA + ( r D ) S + S rPA = (r D0)S r(K S) = rK < 0 . 0 t 2 S2 S The proof for D0 > 0 is much more involved. It can be shown that SF(t) min(K, rK/D0) which implies for PA = K S PA 1 2 2 2PA PA + S rPA = D0S rK < D0SF(t) rK min(D0K, rK) rK 0 . + ( r D ) S 0 t 2 S2 S A similar reasoning applies in case of an American call option: Equality holds true for 0 S < SF(t), whereas strict inequality applies for S SF(t). In the latter case, one has to use SF(t) max(K, rK/D0).

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance
Theorem 6.1 (LCP for American options) The price of an American option satises the LCP V V 1 2 2 2V ( + ( r D ) S + S r V) 0 , 0 t 2 S2 S V (S) 0 , 2 1 V V V + 2 S2 r V) (V (S)) = 0 , + ( r D ) S ( 0 t 2 S2 S where (K S)+ , put option . (S) = (S K)+ , call option

The nal condition is V(S, T) = (S) and the boundary conditions are V(0, t) = K , V(0, t) = 0 ,
S

lim V(S, t) = 0 for a put option , lim V(S, t) = O(S) for a call option .

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance 6.2 Finite Dierence Approximation of the Black-Scholes Inequality
6.2.1 Transformation of the Linear Complementarity Problem As for the Black-Scholes equation, we perform the transformations S 1 x = ln( ) , = 2 (T t) , K 2 1 1 1 exp( (k0 1)x + (k0 1)2 + k ) V(S, t) , u(x, ) = K 2 4
2(rD0 ) 2r where k := 2 and k0 = 2 , and obtain the transformed linear complementarity problem

u 2u 0 , x2

u f 0 ,

u 2u ( )(u f ) = 0 , x2

(Kexp(x)) 1 2 where f (x, ) := exp( 1 ( k 1 ) x + ( k 1 ) + k ) . The initial condition is u(x, 0) = f (x, 0), 0 0 2 4 K and the boundary conditions are given by x x

lim (u(x, ) f (x, )) = 0 , x lim u(x, ) = 0 for a put option , + lim u(x, ) = 0 , x lim (u(x, ) f (x, )) = 0 for a call option . +

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance

6.2.2 Finite Dierence Approximation Discretizing the transformed linear complementarity by nite dierences in time and space in exactly the same way as in case of the transformed Black-Scholes equation (cf. Chapter 5), we obtain the nite-dimensional linear complementarity problem: Find ujh+1 lRN1 such that Ah()ujh+1 bjh 0 ,
j+1 ujh+1 fh 0 , j+1 (Ah()ujh+1 bjh)(ujh+1 fh ) = 0,

j+1 where bjh := Bh()ujh + djh , fh := (f (x1, j+1), ..., f (xN1, j+1))T, and

(1 )

k h2

djh :=

(1 )

k h2

u(a, j) + 0 0 u(+a, j) +

k h2

u(a, j+1)

k h2

u(+a, j+1)

The matrices Ah(), Bh() are given as in Chapter 5 (with = 1).

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance

6.2.3 The discrete LCP and constrained Quadratic Programming (QP) Dropping the indices h, j as well as the dependence on , the discrete LCP reads as follows: Find u lRN1 such that () Au b 0 , u f 0 , (Au b)(u f ) = 0 . Introducing the quadratic objective functional 1 J(v) := vTAv bTv , v lRN1 , 2 and the closed, convex set K := { v lRN1 | vi fi , 1 i N 1 } , the discrete LCP () represents the rst order necessary optimality conditions (Karush-KuhnTucker conditions) of the constrained quadratic programming problem J(u) = min J(v) . vK Since A is symmetric, positive denite, the LCP () is also sucient for a minimizer of (). ()

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance 6.3 Numerical Solution of the Constrained QP
6.3.1 Method of Projected Successive Over-Relaxation (PSOR) Using the min-function, the LCP () can be equivalently written as the problem () min (Au b, u f ) = 0 . As we know from Numerische Mathematik I, the SOR method is based on a triangular decomposition of the spd matrix A lRN1N1 according to A = D L U, where D := diag(A) and L resp. U represent the lower resp. upper triangular part of A. Then, () is equivalent to min (u D1(Lu + Uu + b), u f ) = 0 u = max (D1(Lu + Uu + b), f ) . This equivalence motivates to solve the LCP by the following projected SOR method: Given u(0) lRN1 and 1 < < 2, compute u( +1), 0, according to zi
( ) 1 = a ii (bi i1 j=1

aij uj

( +1)

N1

( +1) ui

= max

( ) (ui

j=i+1 ( ) ( ) (zi ui ), fi)

( ) aij uj ) ,

1iN1 ,

1iN1 .

University of Houston/Department of Mathematics Dr. Ronald H.W. Hoppe Numerical Methods for Option Pricing in Finance
6.3.2 Active Set Strategy For w lRN1 we denote by IAC(w) := {1 i N 1 | wi = fi} , IIN(w) := {1, ..., N 1} \ IAC(w) the active set and the inactive set, respectively. Then, the active set strategy for the solution of the constrained QP () proceeds as follows: Step 1 (Initialization): Choose u(0) lRN1 and determine IAC(u(0)) and IIN(u(0)). Step 2 (Iteration Loop): For 0 compute: ( +1) ( +1) Step 2.1: Set ui = fi, i IAC(u( )), and compute ui , i IIN(u( )), as the solution of the reduced linear system ( +1) aij uj = fi aij fj , i IIN(u( )) . jIIN (u( ) ) jIAC (u( ) ) ( +1) Step 2.2: Determine I (u( +1)) := {i I (u( +1)) | N1 a u < f } and dene
V AC j=1 ij j i

IAC(u( +1)) := IAC(u( +1)) \ IV (u( +1)) , IIN(u( +1)) := {1, ..., N 1} \ IAC(u( +1)) . Step 2.3: If IAC(u( +1)) = IAC(u( )), then STOP, else set := + 1 and go to Step 2.1.