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IMA Journal of Numerical Analysis 2004 24(4):699-720; doi:10.1093/imanum/24.4.699
© 2004 by Institute of Mathematics and its Applications
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A novel fitted finite volume method for the Black–Scholes equation governing option pricing

Song Wang1

1 School of Mathematics & Statistics, The University of Western Australia, 35 Stirling Highway, Crawley, WA 6009, Australia

In this paper we present a novel numerical method for a degenerate partial differential equation, called the Black–Scholes equation, governing option pricing. The method is based on a fitted finite volume spatial discretization and an implicit time stepping technique. To derive the error bounds for the spatial discretization of the method, we formulate it as a Petrov–Galerkin finite element method with each basis function of the trial space being determined by a set of two-point boundary value problems defined on element edges. Stability of the discretization is proved and an error bound for the spatial discretization is established. It is also shown that the system matrix of the discretization is an M-matrix so that the discrete maximum principle is satisfied by the discretization. Numerical experiments are performed to demonstrate the effectiveness of the method.

Received 6 January 2003. Revised 15 January 2004.


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