A numerical method to price discrete double Barrier options under a constant elasticity of variance model with jump diffusion

Abstract

We develop a numerical method to price discrete barrier options on an underlying described by the constant elasticity of variance model with jump-diffusion (CEVJD). In particular, the partial integro differential equation associated to this model is discretized in time using an operator splitting scheme whose accuracy is enhanced by repeated Richardson extrapolation. Such an approach allows us to approximate the differential terms and the jump integral by means of two different numerical techniques. Precisely, the spatial derivatives, which exist only in the weak sense, are discretized using a finite element method based on piecewise quadratic polynomials, whereas the jump integral is directly collocated at the mesh points, so that it can be easily evaluated by Simpson numerical quadrature. As shown by extensive numerical simulation, the proposed approach is very efficient from the computational standpoint, and performs significantly better than the finite difference scheme developed in Wade et al. [On smoothing of the Crank–Nicolson scheme and higher order schemes for pricing barrier options, J. Comput. Appl. Math. 204 (2007), pp. 144–158].

Keywords:

• finite element method
• operator splitting
• Barrier options
• discrete barrier
• CEV model
• jump-diffusion

2010 AMS Subject Classifications:

• 35K20
• 35Q91
• 65M60
• 65N06
• 65M12

Disclosure statement

No potential conflict of interest was reported by the author(s).