JAM Journal of Applied Mathematics 1687-0042 1110-757X Hindawi Publishing Corporation 205686 10.1155/2012/205686 205686 Research Article A Positivity-Preserving Numerical Scheme for Nonlinear Option Pricing Models Zhou Shengwu Li Wei Wei Yu Wen Cui Alwash Mohamad College of Sciences China University of Mining and Technology Jiangsu Xuzhou 221116 China cumt.edu.cn 2012 17 12 2012 2012 31 08 2012 17 11 2012 2012 Copyright © 2012 Shengwu Zhou et al. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

A positivity-preserving numerical method for nonlinear Black-Scholes models is developed in this paper. The numerical method is based on a nonstandard approximation of the second partial derivative. The scheme is not only unconditionally stable and positive, but also allows us to solve the discrete equation explicitly. Monotone properties are studied in order to avoid unwanted oscillations of the numerical solution. The numerical results for European put option and European butterfly spread are compared to the standard finite difference scheme. It turns out that the proposed scheme is efficient and reliable.

1. Introduction

It is widely recognized that the value of a European option can be obtained by solving the linear Black-Scholes equation under quite restrictive assumptions (such as liquid, frictionless, and complete markets) [1, 2]. However, these restrictive assumptions are never fulfiled in reality. In order to conform the actual situation, many modified Black-Scholes models have been proposed in recent years, such as transaction costs (Leland , Palmer , Hoggard et al. , Barles and Soner , and Jandačka and Ševčovič ), illiquid market (Frey and Patie , Sircar and Papanicolaou , Liu and Yong , etc.), and volatility uncertainty (Avellaneda et al. ). These models result in quasilinear or fully nonlinear Black-Scholes equations.

In this paper, we are interested in the option pricing model with transaction costs proposed by Barles and Soner  that are motivated by Hodges and Neuberger . In their model, the value V(S,t) of the option satisfies the following partial differential equation: (1.1)Vt+12σ(VSS)2S22VS2+rSVS-rV=0 with the nonlinear volatility σ(VSS) that reads (1.2)σ(VSS)2=σ02(1+Ψ(er(T-t)a2S22VS2)) and the terminal condition (1.3)V(S,T)=f(S), where S is the price of the underlying asset, T is the maturity date, r is the risk-free interest rate, σ0 is the asset volatility, and a=μγN, with the proportional transaction cost μ, the risk aversion factor γ, and the number N of options to be sold. Ψ(x) is the solution of the following ordinary differential equation: (1.4)Ψ(x)=Ψ(x)+12xΨ(x)-x,x0,Ψ(0)=0.

The existence and uniqueness of the solution of (1.1)–(1.3) have been shown by the theory of stochastic optimal control in . However, analytical solutions cannot be found because of fully nonlinear properties of (1.1); thus, we need to compute the option values numerically.

There have been rich achievements for the numerical method of linear Black-Scholes equations (e.g., see ). As for the nonlinear situation, only a few results can be found. There is a stable numerical scheme developed in  (see also  for application to a general class of nonlinear Black-Scholes equations) for the so-called gamma equation (a quasilinear parabolic equation for the SVSS). Recently Kútik and Mikula  did some progress in showing its stability and accuracy for nonlinear Black-Scholes equation. Company et al.  construct explicit finite difference schemes for (1.1)–(1.3), and consistency and stability are studied. However, they have the disadvantage that strictly restrictive conditions on the discretization parameters are needed to guarantee stability and positivity. The implicit schemes do not have this disadvantage, but they are quite time-consuming. Yousuf et al.  develop a new second-order exponential time differencing (ETD) scheme to avoid unwanted oscillations near the non-smooth nodes for the Hoggard-Whalley-Wilmott (HWW) model  based on the Cox and Matthews approach  and partial fraction version of the matrix exponential, but the theoretical analysis of stability and convergence are not studied. Some authors (for instance, Düring et al.  for European options, Dremkova and Ehrhardt  for American options) construct high-order compact difference schemes with frozen values of the nonlinear coefficient of the nonlinear Black-Scholes equation to make the scheme linear and show that the resulted linearized problem is stable.

On the other hand, since the value of option is nonnegative, it is very important to make numerical schemes preserve the positivity of solution. Several authors have developed some schemes that guarantee the positivity of solutions for ordinary differential equations [27, 28] and parabolic equations . In , Chen-Charpentier and Kojouharov propose an unconditionally positivity-preserving scheme for linear advection-diffusion reaction equations. They construct a nontraditional discretization of the advection and diffusion terms by the approximation of the spatial derivatives using values at different time levels. Motivated by this work, we will develop the method to a nonlinear Black-Scholes equation, and some properties (such as stability, monotonicity, and consistency,) of numerical scheme are studied in this paper. The new numerical method unconditionally preserves the positivity of the solutions, the stability, and monotonicity of the scheme. In addition, the designed numerical approximations allow us to solve the discrete equation explicitly, which reduces the time of calculation and increases the efficiency of the methods.

The rest of the paper is organized as follows. In the next section the original problem (1.1)–(1.3) is transformed into a nonlinear diffusion problem by an appropriate change of variables and some properties of the function Ψ(x) are given. In Section 3, the discretization method is constructed. In Section 4, we prove the boundedness of coefficients, positivity, and monotonicity of the numerical scheme. Stability and consistency are studied in Section 5. In Section 6, numerical experiments for European put option and a European butterfly spread are presented to support these theoretical results. Finally, some conclusions are drawn in Section 7.

2. The Transformed Problem

For the convenience in the numerical processing and the study of the numerical analysis, we are going to transform the problem (1.1)–(1.3) into a nonlinear diffusion equation. Taking the variable transformation (2.1)x=exp(r(T-t))S,  τ=T-t,u=exp(r(T-t))V. the original problem (1.1)–(1.3) is transformed into (2.2)(u)=uτ-12σ02(1+Ψ(a2x22ux2))x22ux2=0,x[0,+),  τ[0,T], with the initial condition (2.3)u(x,0)=f(x) and the boundary condition (2.4)Call  option:  u(0,t)=0,limxu(x,τ)x=1,Put  option:  u(0,t)=K,limxu(x,τ)=0.

The following two lemmas give the properties of the function Ψ appearing in (1.2), which will play an important role in the numerical analysis and numerical calculation.

Lemma 2.1 (see [<xref ref-type="bibr" rid="B20">20</xref>]).

The solution Ψ of ordinary differential equation (1.4) exists and is unique, and it satisfies,

Ψ is an increasing function mapping the real line onto the interval (-1,+).

Ψ=Ψ(A) is implicitly defined by (2.5)A=(- arcsinh ΨΨ+1+Ψ)2if  Ψ>0,A=-(arcsin-ΨΨ+1--Ψ)2  if  -1<Ψ<0,

if A>0, then the function Ψ(A) is bounded and satisfies (2.6)0<Ψ(A)<Ψ(A2)A+d2,

where (2.7)A2=(sinh2-2(sinh2)2+1)29.58,Ψ(A2)=(sinh2)2,Ψ(A2)=(e8+2e4+1)2e16-66e8+11.10,d2=Ψ(A2)-Ψ(A2)A22.62.

Lemma 2.2 (see [<xref ref-type="bibr" rid="B20">20</xref>]).

Let g(A)=AΨ(A), then g(A) is continuously differentiable at A=0 and satisfies (2.8)|g(A)|max{G,2|A|Ψ(A2)+d2},A, where A2 and d2 are given by (2.7), and (2.9)A1=-(4π-33)236,G=max{|g(A)|;  A1AA2}.

3. The Unconditionally Positivity-Preserving Scheme

Since the value of an option is nonnegative, it is important that numerical scheme is positivity preserving.

We see that the problem (2.2) is described in an infinite domain +×[0,T], which makes it difficult to construct scheme effectively. Let us consider the truncated numerical domain Ω=[0,B]×[0,T] and discretize it in the following form. We introduce a grid of mesh points (x,τ)=(xi,τn), where xi=ih,  τn=nk,  i=0,1,,N,  n=0,1,,L, and the spatial step size given by h=B/N, and the time step size is k=T/L. Let us denote the approximation of u(xi,τn) by uin and define the following finite difference approximations of derivatives: (3.1)uτ(xi,τn)uin+1-uink,2ux2(xi,τn)ui+1n-2uin+1+ui-1nh2=δin.

Clearly, the approximation used to calculate the second partial derivative of u with respect to x is nonstandard. From (2.2), we can obtain the positivity-preserving finite-difference numerical scheme as follows: (3.2)uin+1-uink-12σ02(1+Ψ(a2xi2δin))xi2ui+1n-2uin+1+ui-1nh2=0.

Scheme (3.2) is equivalent to (3.3)uin+1=ραin(ui+1n+ui-1n)+uin1+2ραin, where (3.4)ρ=kh2,αin=12σ02(1+Ψ(a2xi2δin))xi2.

Remark 3.1.

From property (i) of Lemma 2.1, Ψ takes values in the interval (-1,+), so the coefficients are nonnegative, that is, αin0 for any i,n.

Obviously, numerical scheme (3.3) is unconditionally positive for a nonnegative payoff ui0. However, we cannot obtain the numerical solution explicitly since the nonlinear term αin involves the value u at the time level n+1, which makes it quite difficult to prove the stability of the scheme presented previously. In fact, the numerical scheme (3.3) can only be solved by a nonlinear iteration in each time step which is quite time-consuming.

In order to obtain an efficient scheme, we correct the approximation of the nonlinear coefficients in (2.2) by using the standard second-order central difference. Thus the corrected numerical scheme is as follows: (3.5)uin+1=ρβin(ui+1n+ui-1n)+uin1+2ρβin, where (3.6)βin=12σ02(1+Ψ(a2xi2Δin))xi2,  Δin=ui+1n-2uin+ui-1nh2.

Since the calculation of (3.5) for i=0 and i=N requires us to know the fictitious values u-1n and uN+1n, we obtain them using the linear extrapolation as follows: (3.7)u-1n=2u0n-u1n,uN+1=2uNn-uN-1n.

Thus the values of boundary points turn out (3.8)u0n+1=u0n==u00=f(0),uNn+1=uNn==uN0=f(B).

The left boundary condition is not needed and in fact must not be prescribed in the case of a parabolic equation with degenerating diffusion term at x=0. This is known in the literature as the Fichera condition  (see  for application in Black-Scholes equations, Chapter 8, (8.25)). The Fichera condition is just a comparison of the speed of degeneration versus. speed of advection at the boundary x=0. Fortunately, the left boundary condition in (3.8) is a consequence of (3.5) with x0=0,  i=0,  u00=f(0). The only boundary condition that can be prescribed is the right boundary condition at x=B. For the convenience in the numerical calculation, let us denote the vectors un=[u0n,u1n,,uNn]T, then numerical scheme (3.5), (3.8) can be written in matrix form (3.9)un+1=C(n)un,u0=[f(0),f(x1),,f(B)]T, where (3.10)C(n)=[10000a1b1c1000a2b2c2000aN-1bN-1cN-100001],(3.11)ai=ci=ρβin1+2ρβin,bi=11+2ρβin,i=1,2,,N-1.

In order to study the related properties of numerical scheme (such as monotonicity and stability), we need to know the behaviour of Δin appearing in the nonlinear team βin.

Lemma 3.2.

With the previous notation, Δin appearing in the nonlinear team βin satisfies the scheme (3.12)Δin+1=ρβi+1n1+2ρβi+1nΔi+1n+ρβi-1n1+2ρβi-1nΔi-1n+11+2ρβinΔin,1iN-1,Δ0n=ΔNn=0,n=0,1,2,,L.

Proof.

From (3.6) and (3.7) we can know for i=0 and i=N that (3.13)Δ0n=ΔNn=0,n=0,1,2,,L.

Putting (3.5) into the expression (3.6) of Δin, and after a simple calculation we can obtain (3.12).

On the other hand, the most common option price sensitivities are the first and second derivatives with respect to the price of the underlying asset, that is, “delta” and “gamma”, respectively. These are important features in risk management and are challenging to compute numerically. From the transformation (2.1) we can obtain the approximations of Greeks of the option as follows: (3.14)Gamma=2VS2(Si,tn)=exp(r(T-t))Δin(u),Delta=VS(Si,tn)=exp(r(T-t))ui+1n-ui-1n2h.

4. Properties of the Numerical Scheme 4.1. Boundedness of the Coefficients

For the sake of convenience, we introduce the following definition.

Definition 4.1 (see [<xref ref-type="bibr" rid="B31">32</xref>]).

If x=[x1,x2,,xN] is a vector in N, then its 1-norm is denoted by x1=i=1N|xi|, and maximum-norm is denoted by x=max1iN|xi|.

The following theorem shows that the nonlinear team βin appearing in (3.5) is bounded.

Theorem 4.2.

Let Δn=[Δ0n,Δ1n,,ΔNn]T, then the following properties hold true.

Δn1 is nonincreasing.

The nonlinear team βin appearing in (3.5) satisfies (4.1)0βinL(h),i=0,1,,N,n=0,1,,L,

where (4.2)L(h)=B2σ022(1+d2+a2B2Δ01Ψ(A2)), with A2, d2, and Ψ'(A2) given by (2.7).

Proof.

Property (i) is proved using the induction principle over index n.

For n=0, from Lemma 3.2 and βin0 by Remark 4.7, it follows that (4.3)|Δi1|ρβi+101+2ρβi+10|Δi+10|+ρβi-101+2ρβi-10|Δi-10|+11+2ρβi0|Δi0|,1iN-1. Taking into account (3.13) and (4.3), we have (4.4)Δ11i=1N-1|Δi0|-ρβ101+2ρβ10|Δ10|-ρβN-101+2ρβN-10|ΔN-10|Δ01. Thus property (i) is proved for n=0.

Now, let us assume that property (i) holds true up n, that is, (4.5)ΔnΔn1Δn-11Δn-21Δ01. For 1iN-1, from Lemma 3.2, it follows that (4.6)|Δin+1|ρβi+1n1+2ρβi+1n|Δi+1n|+ρβi-1n1+2ρβi-1n|Δi-1n|+(1-2ρβin1+2ρβin)|Δin|. Taking into account Δ0n+1=ΔNn+1=0, we have (4.7)Δn+11i=2Nρβin1+2ρβin|Δin|+i=0N-2ρβin1+2ρβin|Δin|+i=1N-1(1-2ρβin1+2ρβin)|Δin|=i=1N-1|Δin|-ρβ1n1+2ρβ1n|Δ1n|-ρβN-1n1+2ρβN-1n|ΔN-1n|Δn1. Hence property (i) is proved completely.

On the other hand, from (3.6) and the monotonic increasing property of Ψ (see Lemma 2.1), it follows that (4.8)βin=12σ02(1+Ψ(a2xi2Δin))xi212σ02(1+Ψ(a2xi2Δn1))xi212σ02(1+Ψ(a2xi2Δ01))xi2.

Since xi[0,B] and from the property (iii) and property (i) of Lemma 2.2, we have (4.9)0βinL(h),i=0,1,,N,n=0,1,,L. Thus the proof of theorem is complete.

4.2. Positivity

Since the value of option is nonnegative, a nice property of the numerical scheme for the pricing equation is positivity-preserving.

Clearly, all the coefficients of the numerical scheme (3.5) are nonnegative (see Theorem 4.2). Hence, for a nonnegative payoff ui0, the following result has been established.

Proposition 4.3.

The numerical scheme (3.5), (3.8) is unconditionally positive.

Remark 4.4.

Δ i n is also unconditionally positive, that is, if Δi00 for 0iN, then Δin0 for 0iN,  0nL.

4.3. Monotonicity

For the sake of convenience in the presentation, we introduce the following definition of a monotonicity preserving numerical scheme.

Definition 4.5 (see [<xref ref-type="bibr" rid="B33">31</xref>]).

In numerical scheme F(uin)=0, we say that it is monotonicity-preserving. If each time that uinui+1n or uinui+1n for all i, then it occurs that uin+1ui+1n+1 or uin+1ui+1n+1 for all i.

The next result shows the monotonicity of the numerical scheme.

Theorem 4.6.

The numerical scheme (3.5), (3.8) is unconditionally monotonicity-preserving with 0iN,  0nL.

Proof.

Let us write (4.10)ui+1n+1-uin+1=(ui+1n+1-ui+1n)+(ui+1n-uin)-(uin+1-uin). Assuming that ui+1nuin for 0iN-1,  0nL-1, then from (3.5), it follows that (4.11)uin+1-uin=ρβin(ui+1n+ui-1n-2uin)1+2ρβinρβin(ui+1n-uin)1+2ρβin,1iN-1,(4.12)uin+1-uin-ρβin(uin-ui-1n)1+2ρβin,      1iN-1, that substituting i by i+1 one gets (4.13)ui+1n+1-ui+1n-ρβi+1n(ui+1n-uin)1+2ρβi+1n,0iN-2. From (4.10), (4.11), and (4.13), it follows that (4.14)ui+1n+1-uin+1-ρβi+1n(ui+1n-uin)1+2ρβi+1n+(ui+1n-uin)-ρβin(ui+1n-uin)1+2ρβin=(1-ρβin1+2ρβin-ρβi+1n1+2ρβi+1n)(ui+1n-uin). Taking into account (4.1) and (4.14) for i and i+1, we have (4.15)ui+1n+1-uin+1(1-2ρL(h)1+2ρL(h))(ui+1n-uin)0,1iN-2.

The monotonicity of the scheme in the internal mesh points has been proved.

In an analogous way, we can verify that (4.16)u1n+1u0n+1,uNn+1uN-1n+1.

Similarly, we can prove that if uinui+1n, then uin+1ui+1n+1 for 0iN-1,  0nL-1.

Thus the proof of theorem is complete.

Remark 4.7.

If the payoff f(x) is nondecreasing with f(0)=0 (e.g., f(x)=max{x-K,0}), then 0=u0nu1nuinui+1nuNn for a fixed n with 0nL.

5. Stability and Consistency 5.1. Stability Theorem 5.1.

The difference scheme (3.5), (3.8) is unconditionally ·-stable.

Proof.

From (3.5), let us write (5.1)uin+1=ρβin1+2ρβin(ui+1n+ui-1n)+(1-2ρβin1+2ρβin)uin. Since all the coefficients of (5.1) are nonnegative, then using triangle inequality, it follows that (5.2)|uin+1|ρβin1+2ρβin(|ui+1n|+|ui-1n|)+(1-2ρβin1+2ρβin)|uin|sup0iN|uin|, so that (5.3)sup0iN|uin+1|sup0iN|uin|. According to the definition of the maximum norm, it follows that (5.4)un+1un. Thus the result is established.

5.2. Consistency

The proposed new difference scheme (3.5) is explicit, unconditionally positive, and unconditionally stable; however, it is not unconditionally consistent. There are extra truncation error terms since the approximations to second derivatives with respect to x are at different time levels.

The following theorem gives the consistency condition of the difference scheme (3.5).

Theorem 5.2.

With the previous notation, suppose that the exact solution u of (1.1)–(1.3) satisfies uC4,2(Ω-). Then the local truncation error is given by (5.5)Th,k(uin)=O(h2)+O(k)+O(kh2).

Proof.

Let us write the scheme (3.5) in the form (5.6)Fh,k(uin)=uin+1-uink-βinδin=0. Using Taylor's expansion about (xi,τn) and uC4,2(Ω-), it follows that (5.7)δin=2ux2(xi,τn)+h2124ux4(η,τn)-2kh2uτ(xi,ξ)=2ux2(xi,τn)+h2Min(1)-kh2Min(2),(5.8)Δin=ui+1n-2uin+1+ui-1nh2=2ux2(xi,τn)+h2124ux4(η,τn),(5.9)uin+1-uink=uτ(xi,τn)+k22uτ2(xi,ξ)=uτ(xi,τn)+kMin(3), where (5.10)xi-h<η<xi+h,τn<ξ<τn+k,|Min(1)|112max{|4ux4(x,τn)|;0xB}=|Wn(1)|max,|Min(2)|2max{|uτ(xi,τ)|;τnττn+1}=|Win(2)|max,|Min(3)|12max{|2uτ2(xi,τ)|;τnττn+1}=|Win(3)|max. From (5.5)–(5.8), it follows that the local truncation error takes the form (5.11)Th,k(uin)=Fh,k(uin)-(uin)=-12σ02xi2{2ux2(1+Ψ(a2xi2Δin))δin12σ02xi2-(1+Ψ(a2xi22ux2(xi,τn)))2ux2(xi,τn)}+kMin(3). Let us introduce the notation (5.12)Ain=a2xi22ux2(xi,τn),δ1Ain=a2xi2h2Min(1),  δ2Ain=-a2xi2kh2Min(2). Using function g(A) introduced in Lemma 2.2, it follows that (5.13)(1+Ψ(a2xi2Δin))δin-(1+Ψ(a2xi22ux2(xi,τn)))2ux2(xi,τn)=a-2xi-2{g(Ain+δ1Ain)-g(Ain)+δ1Ain+(1+Ψ(Ain+δ1Ain))δ2Ain}=g(Ain+θδ1Ain)h2Min(1)+h2Min(1)-kh2βin,0<θ<1. From Lemma 2.2, (5.11), and βinL(h), it is easy to know that (5.14)|Th,k(uin)|O(h2)+O(k)+O(kh2). Thus the result has been proved.

From Theorem 5.2, we can see that the meshes should satisfy k/h20 as k and h go to zero in order to ensure the consistency. Therefore, the key to the convergence of the scheme is the consistency rather than the stability. In actual calculation, we can choose the time step depending on the spatial size so that inconsistent terms go to zero.

6. Numerical Experiments

In this section, we implement the positivity-preserving scheme (3.5), (3.8) on European put option and European butterfly spread. We analyse the effectiveness of the method and compare it with the numerical scheme (SFD1) given in  and a standard forward Euler finite difference scheme (SFD2) (6.1)uin+1-uink-βinui+1n-2uin+ui-1nh2=0, which is analysed in . The function Ψ is calculated with (2.5) using the “fsolve” function in Matlab. Both the experiments are performed for large values of σ0 to visualize the sensitivity of the methods towards high volatility.

6.1. European Put Option

A European put option is a contract where the owner of the option has the right to sell an underlying asset S(t) for a fixed amount, known as the strike price K, at the expiry date T. The payoff function f(S) is given by (6.2)f(S)=max{K-S,0}. We choose the parameters as (6.3)K=2,  T=0.5,  σ0=0.5,B=10,  r=0.04.

Equations (1.1)–(1.3) give analytical solution for only a=0 (see ). Figure 1 (the left one: a=0, the right one: a=0.02) gives the option value using scheme (3.5) and schemes (SFD1 and SFD2) in [20, 21], which shows that our scheme stable, monotonous, and is able to produce solution that is close to the exact solution, but numerical solution of scheme (6.1) appears as spurious oscillation for k=0.0005 and h=0.1.

The values of European put option under different schemes with the computational parameters h=0.1 and k=0.0005.

a = 0

a = 0.02

Moreover, Figure 2 presents the related hedging parameters of European put option using the two schemes. We can see that our proposed scheme produces smoother solutions than standard scheme for the delta and gamma. In addition, the gamma is positivity preserving and is maximal as it closes the strike price K=2.

Time evolution profiles of the Greeks of European put option with the computational parameters h=0.1, k=0.0005, and a=0.02.

Standard scheme for delta

New scheme for delta

Standard scheme for gamma

New scheme for gamma

Next we consider the influence of transaction costs (parameter a) on the value of European put option (Figure 3). The left one shows the change of the option value with the parameter a, and the right one presents an evolution profile of the difference Vnonlinear(S,t)-Vlinear(S,t) between our proposed scheme with transaction costs and without transaction costs. We can see that the difference is not symmetric, but decreases towards the expiry date, and is maximal close to the strike price K=2, where the nonlinear value is significantly higher than the linear value.

Influence of the transaction costs (parameter a) on the value of European put option with the computational parameters h=0.1 and k=0.0005.

Linear and nonlinear cases

Nonlinear-linear (a=0.02)

6.2. European Butterfly Spread

A butterfly spread is a combination of three-call options with three-strike prices, in which one contract is purchased with two outside strike prices and two contracts are sold at the middle strike price. The payoff function f(S) is given by (6.4)f(S)=max{S-K1,0}-2max{S-K2,0}+max{S-K3,0}, where K1,K2, and K3 are the strike prices that satisfy K1<K2<K3 and K2=(K1+K3)/2.

We choose the following parameters: (6.5)r=0.04,K1=0.8,K2=1,K3=1.2,  T=0.5,σ0=0.5,B=10, the time step k=0.000455, and the spatial step h=0.1.

Figure 4 shows the different solutions of two schemes at t=0 for a=0.02. We can see that our proposed scheme is smooth and stable at the same step sizes. Moreover, Figure 5 shows the Greeks of the numerical solution calculated with scheme (3.14), which is different from the vanilla option. The standard scheme (the left one) is unstable and produces unwanted oscillations which are not present while using our proposed scheme (the right one).

The value of European butterfly spread under different schemes with the computational parameters h=0.1, k=0.000455, and a=0.02.

Time evolution profiles of the Greeks of European butterfly spread with the computational parameters h=0.1, k=0.000455, and a=0.02.

Standard scheme for delta

New scheme for delta

Standard scheme for gamma

New scheme for gamma

The last two figures show the value of European butterfly spread with different transaction costs (parameter a). It is evident from Figure 6 that butterfly spread becomes more expensive in the presence of transaction cost and the difference is maximal as it closes the strike price K2=1, which is similar with the vanilla option.

Influence of the transaction costs (parameter a) on the value of European butterfly spread with the computational parameters h=0.1 and k=0.000455.

Linear and nonlinear cases

Nonlinear-linear (a=0.02)

7. Discussions and Conclusions

In this paper, we have extended the numerical method in  to nonlinear situation and presented the numerical scheme for a nonlinear Black-Scholes equation in the presence of transaction costs. The numerical method is based on a nonstandard approximation of the second partial derivative 2u(xi,τn)/x2 by (ui+1n-2uin+1+ui-1n)/h2, and the nonlinear team is treated explicitly, which guarantees to solve the original problem without iteration. The scheme is unconditionally positive and stable, but it is conditionally consistent. In fact, as uin+1uin+k(u/τ)(xi,τn), the scheme effectively solves the nonlinear parabolic equation (7.1)(1+kh2β(x))uτ-12β(x)2ux2=0, where (7.2)β(x)=σ02(1+Ψ(a2x22ux2))x2. It means that the new scheme converges to a solution of (2.2) if k/h20. Otherwise, (if k/h2 is fixed) it converges to a solution of (2.2) in a different time scale. In fact, it can be seen from Theorem 5.2, where the truncation error really depends on the ratio k/h2, which is also the reason that we consider the smaller ratio k/h2 in the experiment. The numerical results show that our method produces better numerical solutions than the schemes in [20, 21] with the same step sizes. In the future work, we will extend the method to the problem of American option pricing.

Acknowledgments

The authors would like to thank the anonymous referees for several suggestions for the improvement of this paper. This work is supported by the Fundamental Research Funds for the Central Universities of China (Grant no. JGK101677).

Black F. Scholes M. The pricing of options and corporate liabilities Journal of Political Economy 1973 81 637 659 Merton R. C. Theory of rational option pricing The Rand Journal of Economics 1973 4 141 183 0496534 Leland H. E. Option pricing and replication with transaction costs Journal of Finance 1985 40 1283 1301 Palmer K. A note on the Boyle—vorst discrete-time option pricing model with transactions costs Mathematical Finance 2001 11 3 357 363 2-s2.0-0035612326 Hoggard T. Whalley A. E. Wilmott P. Hedging option portfolios in the presence of transaction costs Advanced Futures and Options Research 1994 7 21 35 Barles G. Soner H. M. Option pricing with transaction costs and a nonlinear Black-Scholes equation Finance and Stochastics 1998 2 4 369 397 10.1007/s007800050046 1809526 ZBL0915.35051 Jandačka M. Ševčovič D. On the risk-adjusted pricing-methodology-based valuation of vanilla options and explanation of the volatility smile Journal of Applied Mathematics 2005 3 235 258 10.1155/JAM.2005.235 2201973 ZBL1128.91025 Frey R. Patie P. Risk management for derivatives in illiquid markets: a simulation study Advances in Finance and Stochastics 2002 Berlin, Germany Springer 137 159 1929376 ZBL1002.91031 Sircar K. R. Papanicolaou G. General Black-Scholes models accounting for increased market volatility from hedging strategies Applied Mathematical Finance 1998 5 45 82 Liu H. Yong J. Option pricing with an illiquid underlying asset market Journal of Economic Dynamics & Control 2005 29 12 2125 2156 10.1016/j.jedc.2004.11.004 2185277 ZBL1198.91210 Avellaneda M. Levy A. Paras A. Pricing and hedging derivative securities in markets with uncertain volatilities Applied Mathematical Finance 1995 2 73 88 Hodges S. D. Neuberger A. Optimal replication of contingent claims under transaction costs Review of Future Markets 1989 8 222 239 Boyle P. P. Tian Y. An explicit finite difference approach to the pricing of barrier options Applied Mathematical Finance 1998 5 19 43 Zvan R. Forsyth P. A. Vetzal K. R. A General Finite Element Approach for PDE Option Pricing Models 1998 Ontario, Canada University of Waterloo Vázquez C. An upwind numerical approach for an American and European option pricing model Applied Mathematics and Computation 1998 97 2-3 273 286 10.1016/S0096-3003(97)10122-9 1643127 Tangman D. Y. Gopaul A. Bhuruth M. Exponential time integration and Chebychev discretisation schemes for fast pricing of options Applied Numerical Mathematics 2008 58 9 1309 1319 10.1016/j.apnum.2007.07.005 2444259 ZBL1151.91546 Wade B. A. Khaliq A. Q. M. Yousuf M. Vigo-Aguiar J. Deininger R. On smoothing of the Crank-Nicolson scheme and higher order schemes for pricing barrier options Journal of Computational and Applied Mathematics 2007 204 1 144 158 10.1016/j.cam.2006.04.034 2320203 ZBL1137.91477 Sevcovic D. Stehlikova B. Mikula K. Analytical and Numerical Methods for Pricing Financial Derivatives 2011 Hauppauge, NY, USA Nova Science Kútik P. Mikula K. Finite volume schemes for solving nonlinear partial differential equations in financial mathematics Finite Volumes for Complex Applications. VI. Problems & Perspectives 2011 4 Heidelbergm, Germnay Springer 643 651 Springer Proceedings in Mathematics. 10.1007/978-3-642-20671-9_68 2882342 ZBL1246.91150 Company R. Jódar L. Pintos J.-R. A numerical method for European option pricing with transaction costs nonlinear equation Mathematical and Computer Modelling 2009 50 5-6 910 920 10.1016/j.mcm.2009.05.019 2569252 ZBL1185.91174 Company R. Jódar L. Pintos J.-R. Consistent stable difference schemes for nonlinear Black-Scholes equations modelling option pricing with transaction costs Mathematical Modelling and Numerical Analysis 2009 43 6 1045 1061 10.1051/m2an/2009014 2588432 ZBL1175.91071 Company R. Jódar L. Pintos J.-R. Roselló M.-D. Computing option pricing models under transaction costs Computers & Mathematics with Applications 2010 59 2 651 662 10.1016/j.camwa.2009.10.028 2575554 ZBL1189.91203 Yousuf M. Khaliq A. Q. M. Kleefeld B. The numerical approximation of nonlinear Black-Scholes model for exotic path-dependent American options with transaction cost International Journal of Computer Mathematics 2012 89 9 1239 1254 10.1080/00207160.2012.688115 2934804 Cox S. M. Matthews P. C. Exponential time differencing for stiff systems Journal of Computational Physics 2002 176 2 430 455 10.1006/jcph.2002.6995 1894772 ZBL1005.65069 Düring B. Fournié M. Jüngel A. High order compact finite difference schemes for a nonlinear Black-Scholes equation International Journal of Theoretical and Applied Finance 2003 6 7 767 789 10.1142/S0219024903002183 2019728 ZBL1070.91024 Dremkova E. Ehrhardt M. A high-order compact method for nonlinear Black-Scholes option pricing equations of American options International Journal of Computer Mathematics 2011 88 13 2782 2797 10.1080/00207160.2011.558574 2826512 ZBL1237.91228 Burchard H. Deleersnijder E. Meister A. A high-order conservative Patankar-type discretisation for stiff systems of production-destruction equations Applied Numerical Mathematics 2003 47 1 1 30 10.1016/S0168-9274(03)00101-6 2003144 ZBL1028.80008 Dimitrov D. T. Kojouharov H. V. Positive and elementary stable nonstandard numerical methods with applications to predator-prey models Journal of Computational and Applied Mathematics 2006 189 1-2 98 108 10.1016/j.cam.2005.04.003 2202966 ZBL1087.65068 Dang Q. A. Ehrhardt M. Adequate numerical solution of air pollution problems by positive difference schemes on unbounded domains Mathematical and Computer Modelling 2006 44 9-10 834 856 10.1016/j.mcm.2006.02.016 2253755 ZBL1137.65395 Chen-Charpentier B. M. Kojouharov H. V. An unconditionally positivity preserving scheme for advection-diffusion reaction equations Mathematical and Computer Modelling 10.1016/j.mcm.2011.05.005 Fichera G. Sulle equazioni differenziali lineari ellittico-paraboliche del secondo ordine Atti della Accademia Nazionale dei Lincei 1956 5 1 30 0089348 ZBL0075.28102 Golub G. H. Van Loan C. F. Matrix Computations 1996 3rd Baltimore, Md, USA Johns Hopkins University Press xxx+698 Johns Hopkins Studies in the Mathematical Sciences 1417720