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An application of finite elements to option pricing
Author(s) -
Tomas Michael J.,
Yalamanchili Kishore K.
Publication year - 2001
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/1096-9934(200101)21:1<19::aid-fut2>3.0.co;2-p
Subject(s) - finite element method , greeks , piecewise , valuation of options , representation (politics) , mathematics , finite difference methods for option pricing , mathematical optimization , residual , mathematical economics , function (biology) , computer science , economics , black–scholes model , econometrics , mathematical analysis , financial economics , algorithm , engineering , structural engineering , volatility (finance) , evolutionary biology , politics , political science , law , biology
This study applied the finite element method (FEM) to pricing options. The FEM estimates the function that satisfies a governing differential equation through the assembly of piecewise continuous functions over the domain of the problem. Two common representations, a variational functional representation, and a weighted residual representation are used in the application of the method. The FEM is a versatile alternative to other popular lattice methods used in option pricing. Advantages include the abilities to directly estimate the Greeks of the option and allow nonuniform mesh construction. As an illustration of the advantages that the FEM offers, the method was used to price European put options and discrete barrier knock‐out put options. © 2001 John Wiley & Sons, Inc. Jrl Fut Mark 21:19–42, 2001