Numerical Methods for Nonlinear Equations in Option Pricing

This thesis explores numerical methods for solving nonlinear partial differential equations (PDEs) that arise in option pricing problems. The goal is to develop or identify robust and efficient techniques that converge to the financially relevant solution for both one and two factor problems. To illustrate the underlying concepts, two nonlinear models are examined in detail: uncertain volatility and passport options. For any nonlinear model, implicit timestepping techniques lead to a set of discrete nonlinear equations which must be solved at each timestep. Several iterative methods for solving these equations are tested. In the cases of uncertain volatility and passport options, it is shown that the frozen coefficient method outperforms two different Newton-type methods. Further, it is proven that the frozen coefficient method is guaranteed to converge for a wide class of one factor problems. A major issue when solving nonlinear PDEs is the possibility of multiple solutions. In a financial context, convergence to the viscosity solution is desired. Conditions under which the one factor uncertain volatility equations are guaranteed to converge to the viscosity solution are derived. Unfortunately, the techniques used do not apply to passport options, primarily because a positive coefficient discretization is shown to not always be achievable. For both uncertain volatility and passport options, much work has already been done for one factor problems. In this thesis, extensions are made for two factor problems. The importance of treating derivative estimates consistently between the discretization and an optimization procedure is discussed. For option pricing problems in general, non-smooth data can cause convergence difficulties for classical timestepping techniques. In particular, quadratic convergence may not be achieved. Techniques for restoring quadratic convergence for linear problems are examined. Via numerical examples, these techniques are also shown to improve the stability of the nonlinear uncertain volatility and passport option problems. Finally, two applications are briefly explored. The first application involves static hedging to reduce the bid-ask spread implied by uncertain volatility pricing. While static hedging has been carried out previously for one factor models, examples for two factor models are provided. The second application uses passport option theory to examine trader compensation strategies. By changing the payoff, it is shown how the expected distribution of trading account balances can be modified to reflect trader or bank preferences

Multirate timestepping methods for hyperbolic conservation laws

This paper constructs multirate time discretizations for hyperbolic conservation laws that allow different time-steps to be used in different parts of the spatial domain. The discretization is second order accurate in time and preserves the conservation and stability properties under local CFL conditions. Multirate timestepping avoids the necessity to take small global time-steps (restricted by the largest value of the Courant number on the grid) and therefore results in more efficient algorithms

The Euler-Maruyama approximation for the absorption time of the CEV diffusion

A standard convergence analysis of the simulation schemes for the hitting times of diffusions typically requires non-degeneracy of their coefficients on the boundary, which excludes the possibility of absorption. In this paper we consider the CEV diffusion from the mathematical finance and show how a weakly consistent approximation for the absorption time can be constructed, using the Euler-Maruyama scheme

Update on Multirate Timestepping Methods for Hyperbolic Conservation Laws

This paper constructs multirate time discretizations for hyperbolic conservation laws that allow different timesteps to be used in different parts of the spatial domain. The proposed family of discretizations is second order accurate in time and has conservation and linear and nonlinear stability properties under local CFL conditions. Multirate timestepping avoids the necessity to take small global timesteps (restricted by the largest value of the Courant number on the grid) and therefore results in more efficient algorithms. Numerical results obtained for the advection and Burgers equations confirm the theoretical findings

Dynamic p-enrichment schemes for multicomponent reactive flows

We present a family of p-enrichment schemes. These schemes may be separated into two basic classes: the first, called \emph{fixed tolerance schemes}, rely on setting global scalar tolerances on the local regularity of the solution, and the second, called \emph{dioristic schemes}, rely on time-evolving bounds on the local variation in the solution. Each class of $p$-enrichment scheme is further divided into two basic types. The first type (the Type I schemes) enrich along lines of maximal variation, striving to enhance stable solutions in "areas of highest interest." The second type (the Type II schemes) enrich along lines of maximal regularity in order to maximize the stability of the enrichment process. Each of these schemes are tested over a pair of model problems arising in coastal hydrology. The first is a contaminant transport model, which addresses a declinature problem for a contaminant plume with respect to a bay inlet setting. The second is a multicomponent chemically reactive flow model of estuary eutrophication arising in the Gulf of Mexico.Comment: 29 pages, 7 figures, 3 table