A Product Integration Method for the Approximation of the Early Exercise Boundary in the American Option Pricing Problem

TL;DR

This paper introduces a novel product integration method using barycentric rational interpolation to accurately approximate the early exercise boundary in American option pricing, improving upon existing integral equation techniques.

Contribution

It proposes a new product integration approach based on barycentric rational interpolation for solving the nonlinear integral equation of the early exercise boundary.

Findings

The method provides accurate approximations of the early exercise boundary.

Numerical experiments show improved convergence and accuracy over existing approaches.

The approach is validated through comparison with other methods.

Abstract

In this paper, an integral equation representation for the early exercise boundary of an American option contract is considered. Thus far, a number of different techniques have been proposed in the literature to obtain a variety of integral equation forms for the early exercise boundary, all starting from the Black-Scholes partial differential equation. We first present a coherent categorization of exiting integral equation methodologies in the American option pricing literature. In the reminder and based on the fact that the early exercise boundary satisfies a fully nonlinear weakly singular non-standard Volterra integral equation, we propose a product integration approach based on linear barycentric rational interpolation to solve the problem. The price of the option will then be computed using the obtained approximation of the early exercise boundary and a barycentric rational quadrature. The convergence of the approximation scheme will also be analyzed. Finally, some numerical experiments based on the introduced method are presented and compared to some exiting approaches.