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IMA Journal of Numerical Analysis 2003 23(2):241-267; doi:10.1093/imanum/23.2.241
© 2003 by Institute of Mathematics and its Applications
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Numerical convergence properties of option pricing PDEs with uncertain volatility

D. M. Pooley1, P. A. Forsyth1 and K. R. Vetzal2

1 School of Computer Science, University of Waterloo, Waterloo, Ontario, Canada N2L 3G1 2 Centre for Advanced Studies in Finance, University of Waterloo, Ontario, Canada N2L 3G1

The pricing equations derived from uncertain volatility models in finance are often cast in the form of nonlinear partial differential equations. Implicit timestepping leads to a set of nonlinear algebraic equations which must be solved at each timestep. To solve these equations, an iterative approach is employed. In this paper, we prove the convergence of a particular iterative scheme for one factor uncertain volatility models. We also demonstrate how non-monotone discretization schemes (such as standard Crank–Nicolson timestepping) can converge to incorrect solutions, or lead to instability. Numerical examples are provided.

Key Words: nonlinear PDE; option pricing; convergence; viscosity solution; uncertain volatility

Received 5 November 2001. Revised 5 August 2002.


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