Localized kernel-based approximation for pricing financial options under regime switching jump diffusion model

Abstract

In this paper, we consider European and American option pricing problems under regime switching jump diffusion models which are formulated as a system of partial integro-differential equations (PIDEs) with fixed and free boundaries. For free boundary problem arising in pricing American option, we use operator splitting method to deal with early exercise feature of American option. For developing a numerical technique we employ localized radial basis function generated finite difference (RBF-FD) approximation to overcome the ill-conditioning and high density issues of discretized matrices. The proposed method leads to linear systems with tridiagonal and diagonal dominant matrices. Also, in this paper the convergence and consistency of the proposed method are discussed. Numerical examples presented in the last section illustrate the robustness and practical performance of the proposed algorithm for pricing European and American options. Published by Elsevier B.V. on behalf of IMACS