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Higher Order Smoothing Schemes For Inhomogeneous Parabolic Problems With Applications To Nonsmooth Payoff in Option Pricing
Higher Order Smoothing Schemes For Inhomogeneous Parabolic Problems With Applications To Nonsmooth Payoff in Option Pricing
Higher Order Smoothing Schemes For Inhomogeneous Parabolic Problems With Applications To Nonsmooth Payoff in Option Pricing
1–27
A.Q.M. Khaliq
Department of Mathematical Sciences, Middle Tennessee State University
Murfreesboro, TN 37132-0001, USA.
M. Yousuf
Department of Mathematics and Physics, Alfred State College
Alfred, NY 14802, USA
J. Vigo–Aguiar 2
1
Supported in part by grant number No. SAB2003-0266 from the Ministerio de Educación, Cultura y
Deporte, Spain, and by the U.S. National Security Agency under Grant Agreement Number H98230-05-1-
0062. The United States Government is authorized to reproduce and distribute reprints notwithstanding
any copyright notation herein.
2
Supported by grants No. MTM2004-00295 from the Ministerio de Ciencia y Tecnologı́a and No.
SAB2003-0266 from the Ministerio de Educación, Cultura y Deporte, Spain, as well as no. SA024/04
from Junta Castilla y León, Spain.
2 Wade, Khaliq, Yousuf, Vigo-Aguiar
1. Introduction
For homogeneous parabolic partial differential equations (PDE) with nonsmooth initial data,
a family of higher order accurate smoothing schemes has recently been developed by Wade
et al. [22]. Convergence results and numerical experiments show that these schemes can
be more robust than the well known Rannacher smoothing schemes [16, 17] with respect to
spurious oscillations generated through high frequency components in nonsmooth initial or
boundary data. Other papers related to the subject are [2, 3, 4, 5, 9, 16, 17, 20, 24], which,
however, treat cases of nonsmooth data only for the homogeneous case.
Robust schemes for inhomogeneous parabolic partial differential equations with nons-
mooth initial, boundary, or forcing terms have only been lightly treated, for example, in
[3, 4, 9]. In this article we develop a useful family of numerical schemes for advection–
diffusion–reaction equations under conditions of low regularity by extending the aforemen-
tioned techniques of [22]. We then focus on some practical illustrations of the new family of
schemes using important problems in the area of financial mathematics.
Khaliq and Wade [9] have worked on a smoothing strategy for the Crank-Nicolson scheme
using variable time steps for inhomogeneous equations. Using a rational approximation of the
exponential function e−z , designed to have three distinct real poles, Serbin [19] has developed
a fourth order A-stable scheme for inhomogeneous case, although only for smooth data. Voss
and Khaliq [21] have also developed a fourth order scheme for inhomogeneous problems with
smooth data using a rational approximation with four distinct real poles. In these papers the
authors use partial fraction decomposition to deal with the difficulties in computing higher
order matrix polynomials in the denominators, and to allow a parallel implementation. These
schemes are designed to be implemented on serial or parallel machines. For the scheme given
by Serbin [19], three systems must be solved, whereas the scheme developed Khaliq and Voss
[21] requires four systems at each time level.
In contrast to the aforementioned rational approximations, only one algebraic system
arises if the diagonal (2, 2)-Padé is employed instead. However, one disadvantage of using
diagonal Padé schemes is that they are not L-stable, in particular, their symbols converge
to magnitude one at infinity, so that when the initial data is not smooth high frequency
components in the error are not damped out. Here, we develop damping schemes, cf. [22], to
the inhomogeneous case, being careful to preserve the essential properties of parallelizability
and robustness for nonsmooth initial data enjoyed by the original family of schemes.
We shall begin by mentioning a class of single step fully discrete numerical schemes
described by Brenner et al. [3] and summarized in the book of Thomée [20, Ch. 9] since this
will lead us most easily to the introduction of the new family of numerical schemes. This
class of numerical methods achieves optimal order of convergence for smoothing initial data
while avoiding imposing unsatisfactory boundary conditions on the forcing term f and some
of its derivatives, cf. [20]. The inhomogeneous problem considered in [3, 20] satisfies certain
regularity assumptions, and the problem of nonsmoothness of the initial data has not been
sufficiently addressed.
In the presence of nonsmooth data, the diagonal Padé schemes need to have some damping
device to get optimal order convergence, cf. [11, 12, 16, 17, 22]. Our aim is to develop
an implementation strategy to approximate more efficiently and accurately the solution of
the linear inhomogeneous parabolic equation with nonsmooth initial data by synthesizing
various existing ideas. Similar to the approach adopted by Wade et al. [22], our first
Smoothing Schemes for Inhomogeneous Parabolic PDEs 3
basic strategy is to use a positivity preserving Padé scheme at the start as a damping
device followed by a diagonal Padé scheme. The second component of our strategy is a
partial fraction decomposition of the Padé approximants using the algorithm developed by
Gallopoulos and Saad [6] and Khaliq et al. [8]. With these approaches, we shall use partial
fraction decomposition form of the schemes at each time step, which needs only the work of
solving certain robust linear algebraic systems on parallel or serial machines. Even in serial,
it is necessary to implement this split version in order to avoid conditioning problems from
the higher matrix polynomials that would have to be inverted. That complex arithmetic is
necessary adds only a small inconvenience and a fractional amount of extra computational
time, which is compensated for by the robust performance of the higher order schemes.
where Ω is a bounded domain in Rd with lipschitz boundary and A denotes the uniformly
elliptic operator
d X d
X ∂ ∂ ∂
A := − aj,k (x) + bj (x) + b0 (x).
j,k=1
∂x j ∂x k j=1
∂x j
The coefficients aj,k and bj are to be C ∞ (or sufficiently smooth) functions on Ω, aj,k = ak,j ,
b0 > 0, and for some c0 > 0
d
X
aj,k (·)ξj ξk > c0 |ξ|2 , on Ω, for all ξ ∈ Rd .
j,k=1
The initial value problem (2) is reset to be posed in a Hilbert space X, as follows, for the
reason that it makes the analysis simpler. Consider now A to be a linear, selfadjoint, positive
definite closed operator with a compact inverse T , defined on a dense domain D(A) ⊂ X.
The operator A could represent any of {Ah }0<h6h0 , obtained from a spatial discretization
and X could be X = Sh , an appropriate finite dimensional subspace of L2 (Ω), cf. [20].
We assume the resolvent set ρ(A) of A satisfies, for some α ∈ (0, π2 ),
It follows that −A is the infinitesimal generator of an analytic semigroup {e−tA }t>0 which is
the solution operator for (2) below, cf. [14, 20]. There is a standard representation:
1
Z
−tA
E(t) := e = e−tz (zI − A)−1 dz,
2πi
Λ
where Λ := {z ∈ C : | arg(z)| = θ}, oriented so that Im(z) decreases, for any θ ∈ (α, π2 ).
The abstract initial value problem is as follows:
ut + Au = 0, t > 0, u(0) = v ∈ X. (2)
By the Duhamel principle the exact solution of (2) can be written as
Zt
u(t) = E(t)v + E(t − s)f (s)ds. (3)
0
where 0 < k 6 k, for some k, is the time step and tn = nk with 0 6 n 6 n = bt/kc. One
must be careful to respect any lack of regularity in the data and design a computational
procedure that is robust in its convergence properties.
To approximate the solution of (4) in time using vn to denote the computed approximation
of u(tn ), the scheme we consider has the following form:
s
X
vn+1 = r(kA)vn + k Pi (kA)f (tn + τi k), 0 6 n 6 n, v0 = v, (5)
i=1
Ps
which, by writing Rk f (tn ) = i=1 Pi (kA)f (tn + τi k), can be rewritten as
vn+1 = r(kA)vn + kRk (tn ), 0 6 n 6 n, v0 = v.
The functions r (z) and {Pi (z)}si=1 are to be rational functions bounded on the spectrum of
kA, uniformly in k. The distinct real numbers {τi }si=1 would typically be taken as Gaussian
Quadrature points in the interval [0, 1].
For the time stepping scheme (5) to be accurate of order q, it is required that the scheme
satisfy conditions developed by Brenner et al. [3]. The reader may consult [20, Ch. 9] to
fill in various details omitted here for the sake brevity. The following result describes the
accuracy and establishes some equivalence relations, which we then use later.
Smoothing Schemes for Inhomogeneous Parabolic PDEs 5
Proposition 1. [20, L. 9.1] The time discretization scheme (5) is accurate of order q if
and only if
r(z) = e−z + O(k q+1 ), z → 0, (6)
and for 0 6 l 6 q,
s l
!
X l! X (−z)j
τil Pi (z) = e−z − + O(z q−l ), z → 0. (7)
i=1
(−z)l+1 j=0
j!
It is computationally efficient to have r(z) and {Pi (z)}si=1 such that they share the same
poles, which puts an additional constraint on the scheme. By considering, from [20],
N (z) Ni (z)
r(z) = and Pi (z) = , i = 1, 2, ..., s,
D(z) D(z)
with N (z), D(z), and Ni (z) as polynomials, the scheme (5) formally can be rewritten as
s
X
D(kA)vn+1 = N (kA)vn + Ni (kA)f (tn + τi k).
i=1
It is shown in [20] that for the case s = q (s is the number of quadrature points and q is the
accuracy of the scheme) this form as well as the conditions of the proposition can be achieved
by choosing the rational functions r(z) satisfying (6), selecting distinct real numbers, say,
by Gaussian Quadrature, {τi }m i=1 , and finally solving the system
q l
!
j
X l! X (−z)
τil Pi (z) = r(z) − , l = 0, 1, ..., q − 1, (9)
i=1
(−z)l+1 j=0
j!
for the coefficients of the Pi (z). This system (9) is of Vandermonde type (whose determinant
is not zero, the τi are distinct [1]), which gives the rational functions {Pi (z)}qi=1 as linear
combinations of the terms on the right hand side of (9). The only singularities are then
those of r(z). Thus the denominators of the {Pi }qi=1 have the same factors as that of r(z).
If r(z) is bounded for large z, then the right hand sides of (9) are small for large z, and the
numerator of Pi (z) would be of lower degree than its denominator for each i.
For the case when the number of quadrature points s is less than the order of the scheme q,
an alternative formula similar to (9) is given in [20]. The accuracy conditions are reformulated
by defining
l m
(−z)j
X
l! X
δl (z) = r(z) − − τil qi (z), l = 0, 1, ..., q − 1
(−z)l+1 j=0
j! i=1
and
q
(−z)j
q! X
δq (z) = r(z) − .
(−z)q+1 j=0
j!
6 Wade, Khaliq, Yousuf, Vigo-Aguiar
The following useful properties of (n, m)−Padé are given, for example, in Lambert [10]: The
(n, m)−Padé approximant Rn,m to e−z is: (i) A-acceptable if n = m, (ii) A0 -acceptable if
n 6 m, and (iii) L-acceptable if n = m − 1 or n = m − 2.
For example, the Backward Euler scheme is R0,1 (z) = (1 + z)−1 , the Crank-Nicolson
scheme is R1,1 (z) = (1 − 21 z)(1 + 12 z)−1 , and other higher order schemes of present interest
include the following:
1 1 1 2 1
R0,3 (z) = (1 + z + z 2 + z 3 )−1 , R1,2 (z) = (1 − z)(1 + z + z 2 )−1 ,
2 6 3 3 6
1 1 2 1 1 2 −1
R2,2 (z) = (1 − z + z )(1 + z + z ) ,
2 12 2 12
1 2 1 3 1 4 1 5 −1
R0,5 (z) = (1 + z + z + z + z + z ) ,
2 6 24 120
2 1 3 3 1
R2,3 (z) = (1 − z + z 2 )(1 + z + z 2 + z 3 )−1 ,
5 20 5 20 60
1 1 2 1 3 1 1 1 3 −1
R3,3 (z) = (1 − z + z − z )(1 + z + z 2 + z ) .
2 10 120 2 10 120
Smoothing Schemes for Inhomogeneous Parabolic PDEs 7
We shall design our schemes for inhomogeneous problems based on the positivity pre-
serving (0, 2m − 1)–Padé schemes as damping devices. These practical Padé schemes do
well in approximating the exponential function in the sense that their symbols capture the
properties of positivity and monotone convergence to zero at infinity of e−x , x > 0— thus
avoiding the amplification or introduction of oscillations in high frequency components of
the error. Although the first subdiagonal (m-1, m)–Padé schemes are also L-stable and
sometimes have a smaller constant in the local truncation error, their symbols change sign
or their derivatives do, which can cause unphysical oscillations due to amplification in the
error, depending on the relative sizes of the diffusion rate, the spatial mesh size and time
steps.
As an example, let us begin by mentioning the backward Euler scheme for inhomogeneous
problems. Using the rational approximation r(z) = R0,1 (z) and τ1 = 21 , this first order scheme
is vn+1 = R0,1 (kA) vn + kP1 (kA)f tn + 21 k , for which P1 (z) = 1+z
1
. Next, we shall give the
more complicated versions, involving higher order schemes. These standard schemes form
the basis for the new family of damping schemes of this.
1
P1 (z) + P2 (z) = − (r (z) − 1) , (11)
z
1
τ1 P1 (z) + τ2 P2 (z) = 2 (r (z) − 1 + z) ,
z
which results in a fourth order scheme as follows:
where √ √
1 1 − 63 z 1 1 + 63 z
P1 (z) = 1 2 , P2 (z) = 1 2.
2 1 + 12 z + 12 z 2 1 + 12 z + 12 z
The above mentioned scheme performs with fourth order accuracy only if the initial data
has sufficient regularity.
To achieve good convergence and robust performance with diagonal Padé schemes some
damping treatment is necessary. The idea is to use positivity preserving (0, 2m − 1)-Padé
schemes for initial damping and then use diagonal (m, m)-Padé schemes after that. That
the global accuracy of the (0, 2m − 1)-Padé schemes is one less does not matter because
the damping scheme is used only two times, and the local truncation error, one higher than
the global, then truly affects the accuracy. Next, we develop the details for an important
damping scheme in our proposed fourth order numerical method.
1
√ √
11+ 6
3 − 3 z + 61 1 − 3 z 2
P1 (z) = ,
2 1 + z + 21 z 2 + 16 z 3
1
√ √
11+ 6
3 + 3 z + 61 1 + 3 z 2
P2 (z) = .
2 1 + z + 21 z 2 + 16 z 3
where the Pi are solutions of equation (10) when r = R0,2m−1 or Rm,m , respectively. Here,
p > 2 is the number of initial damping steps, where p can always be taken as 2 independent
of m. Taking p > 2, however, can sometimes result in a bit more damping, for example,
p = 4 occasionally works better. Much larger values of p do not give significant improvement.
For √example, the
√ fourth order scheme, using second order Gaussian quadrature points
3− 3 3+ 3
τ1 = 6 , τ2 = 6 , has the following form:
1 1 −1
v1 = 1 + kA + (kA)2 + (kA)3 v0 + kP1 (kA)f (t0 + τ1 k) + kP2 (kA)f (t0 + τ2 k),
2 6
1 1 −1
v2 = 1 + kA + (kA)2 + (kA)3 v1 + kP1 (kA)f (t1 + τ1 k) + kP2 (kA)f (t1 + τ2 k),
2 6
with P1 (kA) and P2 (kA) as
√ √
3− 3 1− 3
1 2 1 1 −1
P1 (kA) = 1+ kA + (kA) 1 + kA + (kA)2 + (kA)3
2 6 6 2 6
√ √
3+ 3 1+ 3
1 1 1 −1
P2 (kA) = 1+ kA + (kA)2 1 + kA + (kA)2 + (kA)3 ,
2 6 6 2 6
and for n > 2
1 1 1 1 −1
1 − kA + (kA)2 1 + kA + (kA)2 vn + kP1 (kA)f (tn + τ1 k)
vn+1 =
2 12 2 12
+kP2 (kA)f (tn + τ2 k),
Smoothing Schemes for Inhomogeneous Parabolic PDEs 9
q1 q1 +q2
X wij X wij
Pi (z) = +2 < , i = 1, 2, ..., m.
j=1
z − c j j=q +1
z − c j
1
Here, Rn,m as well as the Pi have q1 real and 2q2 nonreal poles {cj } , with q1 + 2q2 = n, and
0 0
where wj = Pn,m (cj ) /Qn,m (cj ) and wij = Ni (cj ) /D (cj ) . For the case when m = n, we
utilize
q1 q1 +q2
m
X wj X wj
Rm,m (z) = (−1) + +2 <
j=1
z − cj j=q +1
z − cj
1
and
q1 q1 +q2
X wij X wij
Pi (z) = +2 < , i = 1, 2, ..., m.
j=1
z − c j j=q +1
z − c j
1
q1
P q1P
+q2
2a. (If n < m) Compute vs+1 = yi + 2 < (yi ) ;
i=1 i=q1 +1
10 Wade, Khaliq, Yousuf, Vigo-Aguiar
q1 q1P
+q2
2b. (If n = m) Compute vs+1 = (−1)m vs +
P
yi + 2 < (yi ) .
i=1 i=q1 +1
II. The fourth order scheme, (2, 2) −Padé, works out as follows: q1 = 0, q2 = 1 and
c = −3. − i1.732050807568877,
w = −6. + i10.39230484541327,
w11 = −0.86602540378 + i3.232050807569,
w12 = 0.866025403784 + i0.23205080757.
instead of that given in [20]. Also we consider the case when initial data is nonsmooth. In
this analysis we use the spaces Ḣ s = D(As/2 ) as defined in [20], with norm
N
!1/2
X
|v|s = (As v, v)1/2 = kAs/2 vk = λsj (v, φj )2 ,
j=1
where {φj }N N
j=1 are orthonormal eigenfunctions of A and {λj }j=1 the eigenvalues, which are
positive.
We assume f ∈ Ḣ s to have sufficient regularity. For the starting scheme we use the shorter
notation rs (z) to indicate the (0, 2m − 1)-Padé initial damping scheme and correspondingly
we use just Rk f (tn ) for Rks f (tn ) because context is clear. For the main scheme we utilize
the notation rm (z) for Rm,m (z) and correspondingly Rk f (tn ) = Rkm f (tn ). Also we shall
use the idea that the operator Ek = r(kA) is said to stable in H if kEkn k 6 C for n > 1,
0 < k 6 k, nk 6 t, cf. [20].
Theorem 5.1. [20, Thm. 9.1] Assume A is a self-adjoint operator on a Hilbert space
H and the time discretization scheme (12) is accurate of order q = 2m, where m is a positive
integer. Suppose f (l) (t) ∈ Ḣ 2q−2l for l < q, t > 0. Then there exists a constant C = C(t)
such that
q−1
X Ztn
q (q)
kvn − u(tn )k 6 Ck t−q
n kvk + tn Sl + kf kds , 0 6 n 6 n, 0 < k 6 k. (13)
l=0 0
Also, using E(t) = e−tA , the exact solution of equation (2) can be written as:
1
X n−1
X
u(tn ) = E(tn )v + k E(tn−1−j )Ik f (tj ) + k E(tn−1−j )Ik f (tj ), (16)
j=0 j=2
where
Z1
Ik f (tj ) = E(k − sk)f (tj + sk)ds.
0
12 Wade, Khaliq, Yousuf, Vigo-Aguiar
E n = rm
n−2
(kA)rs2 (kA)v − E(tn )v
X 1
n−2
(kA)rs1−j (kA)Rks f (tj ) − E(tn−1−j )Ik f (tj )
+k rm
j=0
n−1
X
n−1−j
+k rm (kA)Rks f (tj ) − E(tn−1−j )Ik f (tj )
j=2
= E0n + Esn + Em
n
, (respectively)
where E0n is the error for the corresponding homogeneous equation, Esn is the error for the
n
inhomogeneous part of the starting scheme, and the error Em is due to the inhomogeneous
part of the main scheme.
The error term E0n can be approximated by the established result [22, Theorem 3.1] as
follows:
kE0n k = k rm
n−2
(kA)rs2 (kA) − E(tn ) k 6 Ck q t−q
n kvk (17)
n−1−j n
After adding and subtracting rm (kA)Ik f (tj ) in the error term Em and rearranging its
terms, we arrive at
n−1
X n−1
X
n n−1−j n−1−j
Em = k rm (kA) − E(tn−1−j ) Ik f (tj ) + k rm (kA)(Rkm − Ik )f (tj )
j=2 j=2
n n
= Em1 + Em2 . (respectively) (18)
Following the approach given by Thomée [20, Theorem 9.1] we have the following estimate
n n
for Em1 and Em2 ,
n
Rt
kEm1 k 6 Ck q t2n |f |2q ds. (19)
Incorporating (19) into the right hand side of (20), we therefore arrive at the following
estimate for the main scheme:
t
n−1
X q−1
X n−1 Zj+1
X
n
kEm k 6 Ck q+1 |f (l) (tj )|2q−2l + Ck q kf (q) kds. (21)
j=2 l=0 j=2 t
j
Using a similar approach, we can also develop the estimate for the starting scheme as:
t
1
X q−1
X 1 Zj+1
X
kEsn k 6 Ck q+1 |f (l) (tj )|2q−2l + Ck q kf (q) kds, 0 6 n 6 2. (22)
j=0 l=0 j=0 t
j
Smoothing Schemes for Inhomogeneous Parabolic PDEs 13
q−1
X Ztn
6 Ck q tn Sl + Ck q kf (q) kds. (23)
l=0 0
where Sl = sups6tn |f (l) (s)|2q−2l , and (17) together with (23) complete the proof.
6. Numerical Experiments
In this section we demonstrate the performance of the new algorithm on some important
examples form financial mathematics, using a Black-Scholes PDE model. Consider the
following nonself-adjoint advection-diffusion type equation [23] with spatially variable coef-
ficients:
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0. (24)
∂t 2 ∂S ∂S
Here S represents the price of the underlying asset (serving as a space variable), and V (S, t)
the value of the option at time t before the expiry time T ; parameters σ, r and E are the
volatility of the underlying asset, the interest rate, and the exercise/strike price of the option,
respectively. One can find the derivation, background, and technical details of this model
in [7, 13, 23]. To determine V (S, t) uniquely we must specify other conditions that involve
information about the particular option, e.g., initial and boundary conditions.
Our first example is of a so-called butterfly option which has three strike prices. The
payoff for this option has three corners at strike prices. The second example is of a binary
call option whose payoff has a jump discontinuity at the strike price.
Convergence results for Examples 6.1 and 6.2 are obtained using the fourth order PSP(2)
smoothing scheme. In our first experiment, we employ a spatial discretization using a fourth
order central difference scheme and compute combined fourth order convergence in space
and time. In our second experiment, we compute with a very small spatial mesh so that
there is relatively no error in the x variable to show fourth order convergence in time. All
the numerical schemes are implemented in serial, except we use the split versions described
earlier. Without these splittings the higher polynomial functions of the matrices that must
be inverted would cause numerical difficulties.
The Delta of an option is an important parameter in pricing and hedging of that option.
It is the rate of change of the option value with respect to the asset price, [7, 23]. In
our examples, we compute the Delta of an option using the second order central difference
formula:
∂V V k − Vi−1
k
(Si , tk ) ≈ i+1
∂S Si+1 − Si−1
Another important parameter used in hedging strategies is the Gamma of an option. It is the
rate of change of Delta with respect to asset price. If Gamma is small, Delta changes slowly,
14 Wade, Khaliq, Yousuf, Vigo-Aguiar
and adjustments to keep a portfolio Delta neutral need to be made relatively infrequently.
We compute the Gamma of an option using a second order central difference formula:
k
∂2V Vi+1 − 2Vik + Vi−1
k
(S i , t k ) ≈ , (h = Si+1 − Si ).
∂S 2 h2
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0, 0 6 S 6 100, t ∈ [0, 0.5], (25)
∂t 2 ∂S ∂S
with payoff at expiry being
V (S, T ) = max(S − E1 , 0) − 2 max(S − E2 , 0) + max(S − E3 , 0)
where E1 , E2 , and E3 are the three strike prices with E1 < E2 < E3 and E2 = (E1 + E3 )/2.
This is a homogeneous problem with corners in the initial data, i.e. the payoff function, at
E1 , E2 , and E3 ; its Delta has three jump discontinuities. The behavior of Delta at expiry
can be summarized with the following conditions:
0, for 0 6 S < E1 ;
∂V
1, for E1 6 S < E2 ;
lim− = (26)
t→T ∂S
−1, for E2 6 S < E3 ;
0, for S > E3 .
Tables 1 and 2 show the order of convergence for the fourth order undamped scheme
(2,2)-Padé (# 1) and the fourth order smoothing scheme PSP(2) (# 2). The convergence
order is evaluated at the strike price E2 = 0.5. It is clear from Table 1 that the scheme is
not showing fourth order of convergence, while Table 2 shows the expected order of conver-
gence. The column ”Order” represents the exponent on k in the ratio of the error sequence,
computed in the standard fashion as the ratio of the logarithms of the ratios between the
errors and step sizes, respectively. As there is no analytic solution available, the error has
been developed relative to a reference solution computed separately on an extremely fine
grid with the backward Euler scheme. The reference solution at the strike price E2 = 0.5 is
≈ 0.02102705683555.
Figure 1 is the graph of the payoff function for the Butterfly Spread. Time evolution
graphs shown in Figures 2 and 3 are obtained using (2,2)-Padé and PSP(2), respectively.
Figure 2 shows oscillations at the three strike prices E1 , E2 , and E3 since there is irregularity
at these points. These oscillations are recovered using our smoothing scheme as shown in
Figures 3. Figures 4 and 5 show the time evolution plots of Delta for the Butterfly Spread
using (2,2)-Padé and PSP(2) respectively. Figure 4 shows large oscillations at the three strike
prices E1 , E2 , and E3 due to a jump discontinuity at these points. Again these solutions
are accurately recovered using our smoothing scheme as shown in Figure 5. The parameters
used for the Figures 2–5 are as follows: σ = 0.5, r = 0.1, ∆t = 0.2, ∆S = 1.0 and three
strike prices E1 = 40, E2 = 50 E3 = 60.
Smoothing Schemes for Inhomogeneous Parabolic PDEs 15
Table 1. Convergence results for the Butterfly Spread using the undamped (2,2)-Padé scheme. Parameter
values are: x0 = 0, xn = 1, T = 0.5, r = 0.1, and σ = 0.5.
Table 2. Convergence results for the Butterfly Spread using the smoothing scheme PSP(2). We have used
the same parameters as in Table 1.
10
6
Payoff
0
0 10 20 30 40 50 60 70 80 90 100
Asset Price
Figure 1. The Payoff function of the Butterfly Spread cf. [23, p. 259].
16 Wade, Khaliq, Yousuf, Vigo-Aguiar
4.5
3.5
3
Option Value
2.5
1.5
0.5
0
1
0.5
80 90 100
50 60 70
0 20 30 40
Time 0 10
Asset Price
4.5
3.5
3
Option Value
2.5
1.5
0.5
0
1
0.5
80 90 100
50 60 70
0 20 30 40
Time 0 10
Asset Price
0.8
0.6
0.4
0.2
0
Delta
−0.2
−0.4
−0.6
−0.8
−1
1
0.5
0 60 70 80 90 100
Time 20 30 40 50
0 10
Asset Price
Figure 4. The Delta of the Butterfly Spread using the undamped (2,2)-Padé scheme.
0.8
0.6
0.4
0.2
0
Delta
−0.2
−0.4
−0.6
−0.8
−1
1
0.5
0 60 70 80 90 100
Time 20 30 40 50
0 10
Asset Price
Figure 5. The Delta of the Butterfly Spread using the smoothing scheme PSP(2).
18 Wade, Khaliq, Yousuf, Vigo-Aguiar
∂C 1 2 2 ∂ 2 C ∂C
+ σ S + rS − rC = 0, 0 6 S 6 80, t ∈ [0, 0.5], (27)
∂t 2 ∂S 2 ∂S
for the case when the payoff is not continuous. The payoff function for this call option, also
called ‘cash-or-nothing,’ is given as:
A, for S > E;
lim− C(S, t) = (28)
t→T 0, for S < E.
where the constant A > 0 represents the payoff amount at expiry. Discontinuities in the
payoff reduce the order of convergence, which is restored by averaging the payoff as:
A, for S > E;
lim− C(S, t) = A/2, for S = E; (29)
t→T
0, for S < E.
When S = 0, the asset remains at zero for all later times and hence the payoff is zero. This
gives the boundary condition
When S is large, the option is almost certain to pay off the amount A. Therefore after
discounting for interest, we assume
The analytic solution for this digital option, as given in [7, 23], is:
where
log(S/E) + (r − 12 σ 2 )(T − t)
d2 = √ (33)
σ T −t
and N (·) is the cumulative distribution function for a standardized normal random variable:
Zx
1 1 2
N (x) = e− 2 s ds. (34)
2π
−∞
The Delta of the digital call option, partial derivative of (32) with respect to S, has form:
Table 3. Convergence results for the Digital Call option using the (2,2)-Padé. Parameters are: x 0 = 0, xn =
1, T = 0.5, r = 0.05, and σ = 0.2.
Table 4. Convergence results for the Digital Call option using PSP(2).
Tables 3 and 4 show the order of convergence for the fourth order undamped scheme (2,2)-
Padé the smoothing scheme IPSP(2), respectively, at T = 1. It is evident that the ordinary
(2,2)-Padé scheme is not showing the expected fourth order, while IPSP(2) does. The con-
vergence is computed at the strike price E where the payoff has a jump discontinuity. The
analytic solution at the strike price is approximately 0.53232481545376
Figure 6 is the graph of the payoff function for the digital call option. The time evolution
graphs of the digital call option, shown in Figures 7 and 8, are obtained using the (2,2)-Padé
and PSP(2) schemes, respectively. A discontinuity in the payoff function results in spurious
oscillation in the (2,2)-Padé scheme, which are eliminated by the smoothing scheme PSP(2).
Figures 9 and 10 are the time evolution graphs of the Delta function using (2,2)-Padé and
PSP(2) schemes respectively. The parameter used to obtained these graphs are as follows:
σ = 0.3, r = 0.05, ∆t = 0.1, and ∆S = 0.2667. Figure 11 shows the graph of the Gamma
function using the (2,2)-Padé scheme combined with the smoothing scheme PSP(2).
1.1
0.9
0.8
0.7
0.6
Payoff
0.5
0.4
0.3
0.2
0.1
−0.1
0 10 20 30 40 50 60 70 80
Asset Price
0.8
Option Value
0.6
0.4
0.2
0
0.5
0.4 80
0.3 60
0.2 40
0.1 20
0 0
Time
Asset Price
Figure 7. The Digital Call Option using the undamped scheme (2,2)-Padé.
Smoothing Schemes for Inhomogeneous Parabolic PDEs 21
0.8
Option Value
0.6
0.4
0.2
0
0.5
0.4 80
0.3 60
0.2 40
0.1 20
0 0
Time
Asset Price
Figure 8. The Digital Call Option using the smoothing scheme PSP(2).
0.3
0.25
0.2
Option Value
0.15
0.1
0.05
−0.05
0.5
0.4 80
0.3 60
0.2 40
0.1 20
0 0
Time
Asset Price
Figure 9. The Delta of the Digital Call Option using the undamped scheme (2,2)-Padé.
22 Wade, Khaliq, Yousuf, Vigo-Aguiar
0.2
0.1
0.05
0
0.5
0.4 80
0.3 60
0.2 40
0.1 20
0 0
Time
Asset Price
Figure 10. The Delta of the Digital Call Option using the smoothing scheme IPSP(2).
−3
x 10
5
PSP(2)
(2,2)−Pade
4
1
Gamma
−1
−2
−3
−4
−5
25 30 35 40 45 50 55
Asset Value
Figure 11. Comparison of the Gamma values for the Digital Call option using the undamped (2,2)-Padé
scheme and the smoothing scheme IPSP(2). The parameters used for this graph are σ = 0.3, r = 0.05, ∆t =
0.02, and ∆S = 0.5.
Smoothing Schemes for Inhomogeneous Parabolic PDEs 23
0.8
0.6
u
0.4
0.2
0
5
4
0.2
3
0
2 −0.2
−0.4
1 −0.6
0 −0.8
t
x
Figure 12. Time evolution graph of a European call option using (2,2)-Padé.
a dimensionless and forward in time form of (24) is obtained, cf. [23]. We will solve the
transformed equation using parameter values from [13], which is o the form
∂u ∂2u ∂u
= 2 + (c − 1) − cu, t0 6 t 6 tf , a6x6b (37)
∂t ∂x ∂x
7 − 5 exp(−kt)
u(a, t) = 0, u(b, t) = .
5
Figures 12 and 13 are the surface plots of European Call Option in dimensionless form
using (2,2)-Padé and PSP(2), respectively. The parameter values used are σ = 0.8, r = 0.01,
T = 5.0, ∆t = 0.25, and ∆S = 0.02. At x = 0 the payoff has a corner and therefore
its derivative is discontinuous there. The graph for the (2,2)-Padé shows some unwanted
oscillations at x = 0 where as the graph of PSP(2) shows no oscillations. The oscillations at
x = 0 become worse for the delta function shown in Figure 14. Again, these oscillations are
recovered by PSP(2), as shown in Figure 15.
24 Wade, Khaliq, Yousuf, Vigo-Aguiar
0.8
0.6
u
0.4
0.2
0
5
4
0.2
3
0
2 −0.2
−0.4
1 −0.6
0 −0.8
t
x
Figure 13. Time evolution graph of a European call option using PSP(2).
1.4
1.2
0.8
du
0.6
0.4
0.2
0
5
4
0.2
3
0
2 −0.2
−0.4
1 −0.6
0 −0.8
t
x
Figure 14. Time evolution graph of the Delta of a European call option using (2,2)-Padé.
Smoothing Schemes for Inhomogeneous Parabolic PDEs 25
1.4
1.2
0.8
du
0.6
0.4
0.2
0
5
4
0.2
3
0
2 −0.2
−0.4
1 −0.6
0 −0.8
t
x
Figure 15. Time evolution graph of Delta of a European call option using PSP(2).
In this experiment we consider a well known problem given in a number of papers, for
example Voss and Khaliq [21] and Serbin [19]:
∂u ∂u2
= + tν (νx(1 − x) + 2t), (38)
∂t ∂t2
u(0, t) = 0, u(1, t) = 0, t > 0,
u(x, 0) = 0, 0 < x < 1.
This problem has a nontrivial forcing term, although smooth initial data. We present it at
this time to demonstrate that the advantages of the scheme presented in this article are not
only for problems with nonsmooth initial data, but also include more efficient computational
procedures and parallelizability. In addition, to show flexibility in the companion spatial
discretization, we here employ a spatial discretization with the Chebyshev spectral method.
Since the initial data is smooth, the (2,2)-Padé scheme shows fourth order convergence,
yet the IPSP(2) scheme performs about the same and also is more robust to be used with
confidence for more difficult PDE problems. Thomeé [20] has also developed a fourth order
scheme for inhomogeneous problems with smooth data using a (2,2)-Padé approximation
of the matrix exponential function. That scheme in its original form, however, requires
inverting higher order matrix polynomial functions, which present computational difficulty.
Our modified scheme using the partial fraction technique not only does not require inverting
higher order matrix polynomials but also performs computationally more efficiently. For
fourth order convergence, it is only required to solve simple Backward Euler like problems,
albeit with complex arithmetic.
26 Wade, Khaliq, Yousuf, Vigo-Aguiar
Table 5. Convergence results for the Example [19] using the (2,2)-Padé scheme. Parameter values are:
x0 = 0, xn = 1, T = 1, and ν = 3.
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