A power penalty approach to numerical solutions of two-asset American options

This paper aims to develop a power penalty method for a linear parabolic variational inequality (VI) in two spatial dimensions governing the two-asset American option valuation. This method yields a two-dimensional nonlinear parabolic PDE containing a power penalty term with penalty constant λ > 1 and a power parameter k > 0. We show that the nonlinear PDE is uniquely solvable and the solution of the PDE converges to that of the VI at the rate of order O (λ−k/2). A fitted finite volume method is designed to solve the nonlinear PDE, and some numerical experiments are performed to illustrate the usefulness of this method. AMS subject classifications: 65M12, 65M60, 91B28

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