Numerical analysis for Spread option pricing model of markets with finite liquidity: first-order feedback model

Abstract

In this paper, we discuss the numerical analysis and the pricing and hedging of European Spread options on correlated assets when, in contrast to the standard framework and consistent with a market with imperfect liquidity, the option trader's trading in the stock market has a direct impact on one of the stocks price. We consider a first-order feedback model which leads to a linear partial differential equation. The Peaceman–Rachford scheme is applied as an alternating direction implicit method to solve the equation numerically. We also discuss the stability and convergence of this numerical scheme. Finally, we provide a numerical analysis of the effect of the illiquidity in the underlying asset market on the replication of an European Spread option; compared to the Black–Scholes case, a trader generally buys less stock to replicate a call option.

Keywords:

• Spread option pricing
• price impact
• illiquid markets
• Peaceman–Rachford scheme

2010 AMS Subject Classifications:

• 91G20
• 35K15
• 65M06

Work supported by NSERC grant 5-36700, SSHRC grant 5-26758 and MITACS grant 5-26761 (T.A.P.).