Numerical solution of discretised HJB equations with applications in finance

Thesis

We consider the numerical solution of discretised Hamilton-Jacobi-Bellman (HJB) equations with applications in finance.

For the discrete linear complementarity problem arising in American option pricing, we study a policy iteration method. We show, analytically and numerically, that, in standard situations, the computational cost of this approach is comparable to that of European option pricing. We also characterise the shortcomings of policy iteration, providing a lower bound for the number of steps required when having inaccurate initial data.

For discretised HJB equations with a finite control set, we propose a penalty approach. The accuracy of the penalty approximation is of first order in the penalty parameter, and we present a Newton-type iterative solver terminating after finitely many steps with a solution to the penalised equation.

For discretised HJB equations and discretised HJB obstacle problems with compact control sets, we also introduce penalty approximations. In both cases, the approximation accuracy is of first order in the penalty parameter. We again design Newton-type methods for the solution of the penalised equations. For the penalised HJB equation, the iterative solver has monotone global convergence. For the penalised HJB obstacle problem, the iterative solver has local quadratic convergence.

We carefully benchmark all our numerical schemes against current state-of-the-art techniques, demonstrating competitiveness.

Authors: Witte, J

• Publication date: 2011
• DOI: 10.5287/ora-avqgmeovn
• Type of award: DPhil
• Level of award: Doctoral
• Awarding institution: University of Oxford
• Language: English
• Keywords: HJB equation; numerical solution; penalty method
• Subjects: Mathematics