Applied Numerical Mathematics 110 (2016) 159–173

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Applied Numerical Mathematics

www.elsevier.com/locate/apnum

A radial basis function based implicit–explicit method for

option pricing under jump-diffusion models
Mohan K. Kadalbajoo, Alpesh Kumar ∗ , Lok Pati Tripathi
Department of Mathematics and Statistics, Indian Institute of Technology Kanpur, Kanpur 208016, India

a r t i c l e i n f o a b s t r a c t

Article history: In this article, we present a radial basis function based implicit explicit numerical method
Received 27 March 2015 to solve the partial integro-differential equation which describes the nature of the option
Received in revised form 17 June 2016 price under jump diffusion model. The governing equation is time semi discrtized by
Accepted 19 August 2016
using the implicit–explicit backward difference method of order two (IMEX-BDF2) followed
Available online 31 August 2016
by radial basis function based finite difference (RBF-FD) method. The numerical scheme
Keywords: derived for European option is extended for American option by using operator splitting
Radial basis function method. Numerical results for put and call option under Merton and Kou models are given
Finite difference to illustrate the efficiency and accuracy of the present method. The stability of time semi
Option pricing discretized scheme is also proved.
Jump-diffusion models © 2016 IMACS. Published by Elsevier B.V. All rights reserved.
Partial integro-differential equation

1. Introduction

There is evidence to suggest that the Black Scholes model for stock price behavior does not always model real stock
price behavior. Jump can appear at a random time and these jumps can not be captured by the log normal distribution
characteristic of the stock price in the Black Scholes model. To overcome the above shortcoming, several models have been
proposed in the literature. Among these, the jump diffusion models introduced by Merton [23] and Kou [18] are of the most
widely used models. Merton proposed a log-normally distributed process for the jump-amplitudes, whereas Kou suggested
log-double-exponentially distributed process.
The valuation of option under jump diffusion process requires the solution of a partial integro-differential equation
containing a non-local integral term. There are several numerical methods available in the literature to approximate the
above equation. In [1], Almendral and Osterlee presented an implicit second order accurate time discretization with finite
difference and finite element spatial discretization on uniform grid. Andersen et al. [2] proposed an unconditionally stable
alternating direction implicit method for its solution. Song Wang et al. [33] developed a fitted finite volume method for
jump diffusion process. Their method is based on fitted finite volume method spatial discretization and Crank Nicolson
scheme for temporal discretization. More recently, Patidar et al. [24] developed an efficient method for pricing Merton jump
diffusion option, combining the spectral domain decomposition method and the Laplace transform method. The scheme
proposed by d Halluin et al. [9] required to use an iterative procedure to solve discrete equations. The main difficulty with
implicit scheme is due to containing non-local integral term in governing equation, which leads to a dense discretization
matrix where as fully explicit scheme imposed stability restriction on it. An approach based on implicit–explicit schemes
in which integral term is treated explicitly has been proposed by YongHoon Kwon et al. [19] and Briani et al. [3]. More

* Corresponding author.
E-mail address: [email protected] (A. Kumar).

http://dx.doi.org/10.1016/j.apnum.2016.08.006
0168-9274/© 2016 IMACS. Published by Elsevier B.V. All rights reserved.
160 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173

recently Tangman et al. [28] introduced a new scheme called exponential time integration (ETI) scheme to solve the PIDE.
In ETI scheme, the time direction of PIDE is directly tackled by a ‘one step’ formula, which means temporal discretization is
not required. Tangman et al. [28] used the central difference approach with ETI to provide very efficient and second order
accurate result.
Recently, a new method based on radial basis function (RBF) for approximation of spatial derivative in option pricing
equation is under going active research. Application of RBF in one dimension European and American options is given by
Hon et al. [13,14]. Fasshauer et al. [10] solved American option pricing model using penalty method.
Golbabai et al. [12], developed an algorithm based on global collocation for jump diffusion process. Bhuruth et al. [25]
proposed a radial basis function based differential quadrature rule for spatial discretization with exponential time integration
to solve jump diffusion model. In more recent work, Chan et al. [4,6] used new RBF called cubic spline as basis function to
solve PIDE, and show that their scheme is second order accurate.
It was recognized that standard approach to solving the radial basis function collocation problem has been ill conditioned
due to use of collocation in global sense. Recently many strategies have been developed in the literature to avoid these
problems, such as local RBF approach by Lee et al. [21], radial point interpolation method proposed by Liu et al. [22], Shu
et al. [27] proposed a local radial basis function-based differential quadrature method and used it to solve two-dimensional
incompressible Navier–Stokes equations. Tolstykh [30], Tolstykh and Shirobokov [31], Wright et al. [11,32] proposed radial
basis function finite difference method, the idea is to use radial basis functions with a local collocation as in finite difference
mode thereby reducing number of nodes and hence producing a sparse matrix. This technique is further extended by
Sanyasiraju et al. [7,26] for convection diffusion type equations. However these methods have not been extended to solve
partial integro differential equation yet. In the present work, we have extended the localization concept proposed by Wright
and Fornberg, to solve jump diffusion models. The governing equations are discretized by a three level implicit and explicit
time scheme followed by RBF based finite difference method.
The paper is organized as follows. In section 2, mathematical models for pricing option with jump diffusion process
are given in terms of partial integro-differential equations and provide a brief review of both the Merton and Kou jump
diffusion models. Section 3 deals with the construction of three time level implicit explicit scheme to discretize the jump
diffusion model. The time semi discrete equation is coupled with radial basis function based finite difference method for
spatial discretization. Section 4 provides extension of proposed method for pricing American option by utilizing concept of
operator splitting method. In section 5, we give some numerical results for Merton and Kou model and a comparison of the
accuracy of our solution with finite difference and finite element method for both American and European options. Finally
the paper ends with some conclusive remarks in section 6.

2. The mathematical model

In this section, we give brief discussion about the mathematical model for option with jump diffusion process. Consider
an asset with the asset price S, then the movement of stock price is modeled by the following stochastic differential
equation

dS
= (ν − κ λ)dτ + σ d Z + (η − 1)dq (2.1)
S
where, ν is drift rate, τ as the time to maturity, σ represents the constant volatility, d Z is an increment of standard
Gauss–Wiener process. The term λ is the intensity of the independent Poisson process dq with

0 with probability 1 − λdτ ,
dq =
1 with probability λdτ .

The expected relative jump size E(η − 1) is denoted by κ , where E[·] is the expectation operator and η − 1 is a impulse
function producing jump from S to S η .
Let V ( S , τ ) represent the value of a contingent claim that depends on the underlying asset price S with current time τ .
Then V ( S , τ ) satisfy following backward partial integro differential equation

∞
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + (r − λκ ) S − (r + λ) V + λ V ( S η) g (η)dη = 0, (2.2)
∂τ 2 ∂S ∂S
0

for ( S , τ ) ∈ (0, ∞) × (0, T ], where, r is risk free interest

∞ rate and g (η) is probability density function of the jump with
amplitude η with properties that ∀η , g (η) ≥ 0 and 0 g (η)dη = 1.
The value of V at the expiry date is given by,

V ( S , T ) = G ( S ), S ∈ (0, ∞), (2.3)

where G ( S ) is the pay-off function for the option contract. Under Merton’s model g (η) is given by the log-normal density
 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173 161

(ln η−μ J )2
1 −
2σ 2
g (η) := √ e J . (2.4)
2πσ J η
σ2
In this case κ := E(η − 1) = exp(μ J + 2J ) − 1, where μ J and σ 2J are the mean and the variance of jump in return. Under
a modified version of Kou’s jump-diffusion model g (η) is the following log-double-exponential density

1 
g (η) := p η1 e −η1 ln(η) H(ln(η)) + qη2 e η2 ln(η) H(− ln(η)) , (2.5)
η
where η1 > 1, η2 > 0, p > 0, q = 1 − p, and H(·) is the Heaviside function. We can show that κ : ηp1η−11 + ηq1η+21 − 1.
By using change of variable x = ln( KS ), y = ln(η), where K is strike price and letting t = T − τ , computation of the option
value requires solving the PIDE

∞
∂ u 1 2 ∂ 2u σ2 ∂u
= σ + (r − − λκ ) − (r + λ)u + λ u ( y , t ) f ( y − x)dy , (2.6)
∂t 2 ∂ x2 2 ∂x
−∞

where u (x, t ) := V ( K e x , T − t ) and f ( y ) = g (e y )e y , under the above transformation the function f ( y ) can be written as;
⎧
⎪
⎪ −
( y −μ J ) 2
⎨ 2σ 2
√ 1 e J Merton’s model,
f ( y ) := 2πσ J (2.7)
⎪
⎪
⎩ p η e −η1 y H( y ) + qη e η2 y H(− y ) Kou’s model.
1 2

The initial condition and asymptotic behavior of the price of a European put option is described by

u (x, 0) = max( K − K e x , 0) (2.8)


K e −rt − Ke x
x → −∞,
u (x, t ) = (2.9)
0 x → ∞.

Other types of initial and boundary conditions can be suitably defines for different types options.
In contrast, the American option can be exercised at any time up to the maturity date and can be formulated as the
linear complementarity problem (LCP) of the form
⎧ ∂u
⎨ ∂ t − L u ≥ 0,
u (x, t ) − G (x) ≥ 0, (2.10)
⎩ ∂u
( ∂ t − Lu )(u (x, t ) − G (x)) = 0,
for (x, t ) ∈ (0, ∞) × [0, T ) together with the boundary conditions

K − K ex x → −∞,
u (x, t ) = (2.11)
0 x → ∞,

where L is the partial integro differential operator on the right side of (2.6).

3. Discretizations

In this section we shall construct an implicit explicit time semi discretization for following PIDE on truncated domain
:= (xmin , xmax ),
∂ u (x, t )
= D u (x, t ) + λI u (x, t ), (x, t ) ∈ × [0, T ) (3.1)
∂t
u (x, 0) = G (x), x∈ ¯ (3.2)
where D is differential operator and I is integral operator of L such that

1 ∂ 2u σ2 ∂u
D u (x, t ) = σ2 + (r − − λκ ) − (r + λ)u , (3.3)
2 ∂ x2 2 ∂x
∞
I u (x, t ) = u ( y , t ) f ( y − x)dy . (3.4)
−∞
162 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173

In order to approximate the integral operator I u in (3.4) numerically, we first divide the integral into two parts on and
on c := R \ . Now the integral operator can be split as

I u (x, t ) = u ( y , t ) f ( y − x)dy + R (t , x). (3.5)

By using asymptotic behavior of the option the integral over R \ is given by


R (t , x) := ( K e −rt − K e y ) f ( y − x)dy . (3.6)
c

For the European put option the expression R (t , x) is given as;

⎧   
σ2
⎪
⎨ K e −rt N xmin −x−μ J − K e x+μ J + 2J N xmin −x−μ J −σ 2J
σJ σJ Merton’s ,
R (t , x) := (3.7)
⎪
⎩
p )e −rt +η2 (xmin −x) e −η2 x+(η2 +1)xmin
η2
K (1 − − K (1 − p ) η2 +1 Kou’s.

In the case of American put option above expression can be reformulated as;
⎧   
σ2
⎪
⎨ K N xmin −x−μ J − K e x+μ J + 2J N xmin −x−μ J −σ 2J
σJ σJ Merton’s,
R (t , x) := (3.8)
⎪
⎩
K (1 − p )e η2 (xmin −x) − K (1 − p ) η + e −η2 x+(η2 +1)xmin
2 η
Kou’s,
2 1

where N (·) is the cumulative normal distribution.

We use composite trapezoidal rule to approximate the integral term on truncated domain .

3.1. Time discretizations

Let {0 = t 0 < t 1 < . . . < t N = T ; tn − tn−1 = δt , 1 ≤ n ≤ N } be a partition of the interval [0, T ]. Let us use the notation
un := u (x, tn ) then equation (3.1) will be discretized by following implicit explicit scheme,

1 3 1
un+1 − 2un + u n −1 = D un+1 + λI ( Eun ), n ≥ 1, (3.9)
δt 2 2
together with boundary condition

un+1 (xmin ) = K e −rtn+1 − K e xmin

(3.10)
un+1 (xmax ) = 0,

where Eun = 2un − un−1 .

The above discretization method is called IMEX-BDF2 method with three time levels. In order to use the proposed
method we need two initial values on the zeroth and first time level. The value u 0 at the zeroth time level is given
by initial condition of the model problem, and the value u 1 can be obtained by applying the implicit–explicit backward
difference method of order one,

u n +1 − u n
= D u n +1 + λI u n , (3.11)
δt
together with boundary condition

un+1 (xmin ) = K e −rtn+1 − K e xmin

(3.12)
un+1 (xmax ) = 0.
Now we prove the stability of the time discrete scheme (3.9).
It can be easily shown that for all u (·, t ) ∈ L 2 ( ), t ∈ (0, T ) such that

u (x, t ) : (x, t ) ∈ × [0, T ],
ū (x, t ) =
0 : (x, t ) ∈ c
× [0, T ],
the integral operator satisfies the condition

I ū (·, t ) ≤ C I u (·, t ) , (3.13)


for some constant C I independent of t, where v := ( | v (x) | dx)
2 1/ 2
.
 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173 163

Let us suppose that un be the solution of the equation (3.9) and ũn be the solution of perturbed equation

1 3 1
ũn+1 − 2ũn + ũn−1 = D ũn+1 + λI ( E ũn ) + δn+1 , n ≥ 1, (3.14)
δt 2 2
together with boundary condition

ũn+1 (xmin ) = K e −rtn+1 − K e xmin

(3.15)
ũn+1 (xmax ) = 0.

The δ j is the perturbation in the data at any time level t j and what we will examine the effect of these perturbations on
the error as we proceed in time. We will show that the error at any time level is bounded by the initial errors at initial
time levels (t 0 & t 1 ; for BDF2) and is a bounded multiple of the introduced perturbations; which establishes stability in
time discretization.
Now define the error term en := ũn − un . Since, we are treating boundary conditions exactly in the equations (3.9)–(3.10)
and perturbed equations (3.14)–(3.15). Hence the error term en will be zero at the boundary points.

Theorem 1. (L 2 -stability) For sufficiently small δt such that δt < (2+4α1+2λC ) , we have
I

T
em 2
≤ C ( e0 2
+ e1 2
+ max δ j 2
), ∀ 2 ≤ m ≤ , (3.16)
2≤ j ≤m δt
2
(r − σ2 −λκ )2 −2(r +λ)σ 2
where α =| 2σ 2
| and C is generic constant depending on the parameter C I , r, σ , λ, and T .

Proof. Relations (3.9)–(3.10) and (3.14)–(3.15) imply that the error term en satisfies the following relations

(3en+1 − 4en + en−1 )

= Den+1 + λI ( Een ) + δn+1 , (3.17)
2δ t
en+1 (xmin ) = 0
(3.18)
en+1 (xmax ) = 0.

Taking the inner product of the equation (3.17) with en+1 , we obtain;
      
(3en+1 − 4en + en−1 ) n+1
,e = Den+1 , en+1 + λ I ( Een ), en+1 + δn+1 , en+1 ,
2δ t
σ 2 n +1 2 σ2  
=− ex + (r − − λκ ) enx +1 , en+1 − (r + λ) en+1 2
2 2
   
n +1
n
+ λ I ( Ee ), e + δ n +1 , e n +1 (3.19)

by simplification of the above relation we have

  2 
(3en+1 − 4en + en−1 ) n+1 σ2 n +1
(r − σ2 − λκ ) n+1 2
,e =− ex − e
2δ t 2 σ2
2
(r − σ2 − λκ )2 − 2(r + λ)σ 2  
+ 2
e n +1 2
+ λ I ( Een ), en+1
2σ
 
n +1 n +1
+ δ ,e
2
(r − σ2 − λκ )2 − 2(r + λ)σ 2  
≤ e n +1 2
+ λ I ( Een ), en+1
2σ 2
 
n +1 n +1
+ δ ,e
   
≤ α e n +1 2
+ λ I ( Een ), en+1 + δn+1 , en+1 , (3.20)

2
(r − σ2 −λκ )2 −2(r +λ)σ 2
where α =| 2σ 2
|.
Now by using the relation 2 (3a − 4b + c , a) = a 2
− b 2
+ 2a − b 2
− 2b − c 2
+ a − 2b + c 2
, we have
164 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173

1    
e n +1 2
− en 2
+ 2en+1 − en 2
− 2en − en−1 2
≤ α en+1 2 + λ I ( Een ), en+1
4δ t
 
+ δ n +1 , e n +1
1  
e n +1 2
− en 2
+ 2en+1 − en 2
− 2en − en−1 2
≤ α e n +1 2
+ λC I Een e n +1
4δ t
+ δ n +1 e n +1
1  n +1  1 λC I
e 2
− en 2
+ 2en+1 − en 2
− 2en − en−1 2
≤ (α + + ) e n +1 2
4δ t 2 2
λC I 1
+ Een 2
+ δ n +1 2
2 2
1   1 λC I
e n +1 2
− en 2
+ 2en+1 − en 2
− 2en − en−1 2
≤ (α + + ) e n +1 2
4δ t 2 2
+ λC I (4 en 2
+ e n −1 2
)
1
+ δ n +1 2
2
e n +1 2
− en 2
+ 2en+1 − en 2
− 2en − en−1 2
≤ δt [(2 + 4α + 2λC I ) en+1 2
+ 2 δ n +1 2

+ 16λC I en 2
+ 4λ C I e n −1 2
]
After summing up for n between 1 to m − 1, we get


m
em 2
− e1 2
− 2e 1 − e 0 2
≤ δt [4λC I e 0 2
+ 20λC I e 1 2
+2 δj 2

j =2


m −1
+ (2 + 4α + 22λC I ) ej 2
+ (2 + 4α + 2λC I ) em 2
]
j =2

Now consider the δt sufficiently small such that 1 − δt (2 + 4α + 2λC I ) > 0 that is δt < (2+4α1+2λC ) , then above relation
I
implies that


m 
m −1
em 2
≤ C ( e0 2
+ e1 2
+ δt δj 2
+ δt ej 2
)
j =2 j =2


m −1
≤ C ( e0 2
+ e1 2
+ mδt max δ j 2
+ δt ej 2
).
2≤ j ≤m
j =2

Since mδt ≤ T . Therefore, we have


m −1
em 2
≤ C ( e0 2
+ e1 2
+ max δ j 2
+ δt ej 2
), (3.21)
2≤ j ≤m
j =2

where C is a generic constant which is independent of mesh length. Now by applying the discrete Gronwall’s inequality,
(for more detail see Lemma 3.1 in [17]) we get the result. 2

We solve the resulting time semi discrete scheme by using radial basis function based finite difference method discussed
in the next sub section.

3.2. Space discretizations

A function : Rd → R is called radial provided there exists a univariate function φ : [0, ∞) → R such that (x) = φ(r ),
where r = x and · is Euclidean norm on Rd . These functions can be broadly classified into two classes, infinitely smooth
and piecewise smooth radial basis functions. The former include a shape parameter  , and upon varying this parameter the
radial function can vary sharp peak to very flat one. Classical choices of RBF are given in Table 1 with their order, where
for any x ∈ R, the symbol x denotes as usual the smallest integer greater than or equal to x. The Gaussian and inverse
multiquadric are positive definite functions where as multiquadric are conditionally positive definite functions of order
m > 0.
 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173 165

Table 1
Examples of radial basis functions and their order.

R.B.F. φ(r ), r > 0 Order of RBF

Multiquadric (MQ) (1 + ( r )2 )υ , υ > 0, υ ∈
/N m= υ
Inverse multiquadric (IMQ) (1 + ( r )2 )υ , υ < 0, υ ∈
/N m=0
e −( r )
2
Gaussian (GA) m=0

k
To derive local RBF-FD approximation of any linear differential operator L := d k of order k at a specific node point xi ,
dx
in the discretized domain := {x1 , x2 , . . . , xn } containing n number of nodes, consider any subset i containing ni (<< n)
nodes in the neighborhood of xi . In RBF-FD approach we are required to compute weights such that;


ni
L u ( xi ) = w j u (x j ), (3.22)
j =1

where ni and w j are known as the stencil size and differential weights respectively.
For each node xi ∈ we compute the weights w j on each local support i . In traditional method, generally these nodes
are equidistant and the weights are computed using classical polynomial interpolation. At the same time in radial basis
function interpolation on randomly distributed nodes is used.
Let s(x) be radial basis function interpolant that interpolates function u (x) at the interpolation points contained in i .
Then s(x) can be represented by


ni

l
s(x) = λ j φ( x − x j ) + γ j p j (x) (3.23)
j =1 j =1
d
where · is the Euclidean norm and { p j (x)}lj =1 denote basis of m−1 , which is space of d-variate polynomials of total
degree ≤ m − 1, where m is order of φ . The coefficients λ j and γ j are evaluated by imposing the following conditions

s(xi ) = u (xi ), 1 ≤ i ≤ ni (3.24)


ni
λ j p k ( x j ) = 0, 1 ≤ k ≤ l. (3.25)
j =1

Imposing conditions (3.24)–(3.25) on s(x) gives a linear system

    
P λ u|
= i
(3.26)
P O γ O

where := (φi j )1≤i , j≤ni := (φ xi − x j )1≤i , j ≤ni ∈ Rni ×ni , P := ( p j (xi ))1≤i ≤ni ,1≤ j≤l ∈ Rni ×l .
Suppose φ is conditionally positive definite function of order m on Rd and the points i := {xi ∈ Rd ; i = 1, 2, . . . , ni } form
(m − 1) unisolvent set of centers. Then the system (3.26) is uniquely solvable.
The differential weights w j are calculated by enforcing the linear combination (3.22) should be exact for RBFs {φ( x −
n
xi )}i =i 1 , centered at each of the stencil evaluation points. Hence by using RBFs and polynomial up to degree l, the weights
are obtained by solving the following linear system
    
]
n
P w [L φ( xi − x j ) j = i
1
= (3.27)
P O v [L p j (xi )lj =1 ]

note that the right hand side of equation (3.27) is nothing but [L φ( xi − x1 ) L φ( xi − x2 ) . . . L φ( xi − xni ) |
L p 1 (xi ) L p 2 (xi ) . . . L pl (xi )] .
It is obvious from the linear system (3.27) that its size is only ni + l, which is much smaller than the size n + l of global
RBF collocation system. Thus the proposed method provides more stable system for a wide value of shape parameter  .

Algorithm to evaluate an European option

Then the approximated value of the solution unm = u (xm , tn ) denoted by U m
n
can be obtained by following time stepping
problem;

for n = 0 : N − 1
if n ≤ 1
n +1
Um −U m
n
n+1
δt = D U m + λI U m
n

else
166 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173

 
3 n+1 n−1 n+1
1
δt U
2 m
− 2U m
n
+ 12 U m = D U m + λI ( E U m
n
)
end
end

where D U is local RBF based space discretization of differential operator D u, obtained by using procedure described
above and I is numerical approximation of integral operator defined by equation (3.5). Since the option price problem
have non-smooth payoff function, there is possibility to have oscillation on the final time level. To overcome this problem,
the solution on two time levels is calculated by implicit Euler method.

4. American options

The RBF based IMEX method discussed in previous section can be extend to solve LCP (2.10) for American option problem
coupled with operator splitting method. The operator splitting method was introduced by Ikonen and Toivanen[15,16] to
evaluate the American put option. The basic idea behind the operator splitting method is the formulation with the auxiliary
variable ψ such that ψ = ut − Lu. Now the reformulated LCP (2.10) as
⎧ ∂u
⎪
⎪ ∂ t − Lu = ψ,
⎨
(u (x, t ) − G (x)) · ψ = 0,
(4.1)
⎪
⎪ u (x, t ) − G (x) ≥ 0,
⎩
ψ ≥ 0,
in the region × [0, T ).
Let us split the governing equation ut − Lu = ψ on the (n + 1)th time level into two discrete equations as
  
1 3 n +1 n 1 n −1 n +1 n n
Ũ m − 2U m + Um − D Ũ m + λ I ( E U m ) = m , (4.2)
δt 2 2
  
1 3 n +1 n 1 n −1 n +1 n n +1
Um − 2U m + Um − D Ũ m + λ I ( E U m ) = m . (4.3)
δt 2 2

Now the discrete problem for LCM (4.1) is to look for the pair (U n+1 ,  n+1 ), which satisfy the discrete equations (4.2)
and (4.3) and the constrains
⎧ n +1
⎨ Um ≥ G (xm ),
n +1
m ≥ 0, (4.4)
⎩ n +1 n +1
m (U m − G (xm )) = 0.
n+1
The first step is to compute the intermediate approximation Ũ m by solving the equations (4.2) with known auxiliary
n
term m .
n+1 n+1
Now the second step of the operator splitting method is to derive a relationship in (4.3) between U m and m . To
do this rewrite the equation (4.3) using equation (4.2) together with the constrains in (4.4) as a problem to find the pair
n+1 n+1
(U m , m ), such that
 n +1 n +1
3 U m −Ũ m n +1
2 δt = m − m
n
, (4.5)
n +1 n +1
m (U m − G (xm )) = 0,
with the constrains
n +1 n +1
Um ≥ G (xm ) and m ≥ 0. (4.6)
Now by solving the problems (4.5)–(4.6), we get
 n +1
n +1
(U m n +1
, m ) = (G (xm ), mn
+ 32 G (xm )−
δt
Ũ m n +1
) if Ũ m − 23δt m
n
≤ G (xm ), (4.7)
n +1 2δ t n
(Ũ m − 3 m , 0) otherwise.

Thus, one can do the second step by solving discrete equation (4.2) with the updating formula (4.7). The above implicit
0 0
method with three time levels requires the value on previous two time levels. The pair (U m , m ) on zeroth time level can
be obtained by using initial condition and assign value m 0
= 0 or one can use the algorithm discussed in [20]. To find the
1 1 1
pair (U m , m ) at first level, the first step is to compute the intermediate value Ũ m as follows:
1
Ũ m − Um
0  
1 0 0
− D Ũ m + λ I U m = m . (4.8)
δt
1 1
The second step is to find the pair (U m , m ) such that
 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173 167

Table 2
Numerical results for European put options under the Merton model at different asset price with parameters as
given in Example 1.

M N S = 90 S = 100 S = 110
Value Error Value Error Value Error
129 25 9.283266 2.1520e–03 3.120808 2.8218e–02 1.396156 5.0297e–03
257 50 9.284893 5.2475e–04 3.142100 6.9262e–03 1.399881 1.3053e–03
513 100 9.285282 1.3655e–04 3.147302 1.7240e–03 1.400852 3.3346e–04
1025 200 9.285384 3.4508e–05 3.148595 4.3054e–04 1.401101 8.5126e–05
2049 400 9.285409 8.7377e–06 3.148918 1.0776e–04 1.401165 2.1274e–05
4097 800 9.285416 2.5525e–06 3.148998 2.7723e–05 1.401180 5.5654e–06

 1
G (xm )−Ũ m
1
(U m 1
, m ) = (G (xm ), m0
+ δt ) 1
if Ũ m − δt m
0
≤ G (xm ), (4.9)
(Ũ m − δt m
1 0
, 0) otherwise.

Algorithm to evaluate an American option

for n = 0 : N − 1
if n ≤ 1
n +1
Ũ m −U m
n
n+1
δt = D Ũ m + λI U m
n
+ m
n

n+1 n+1
U m = max(Ũ m − δt m , G (xm ))
n
n+1 n +1
n+1 Um −Ũ m
m = m
n
+ δt
else 
3 n+1 n−1 n+1
1
δt Ũ
2 m
− 2U m
n
+ 12 U m = D Ũ m + λI ( E U m
n
) + m
n

n+1 n+1
Um = max(Ũ m − 23δt m
n
, G (xm ))
n+1 n+1
n+1 3 U m −Ũ m
m = m
n
+ 2 δt
end
end

5. Numerical simulation and discussion

In this section, we present several numerical experiments to illustrate the efficiency and accuracy of proposed method.
We used the FFT algorithm to compute the product of a dense matrix and a column vector in the discrete integral operator
in (3.5). Thus the implicit–explicit method with three time levels requires totally O ( M N log2 ( M )) operations, where N is the
number of time steps and M is the number of spatial nodes. Numerical results are presented for both call option and put
option under Merton and Kou model using multiquadric (with υ = 12 and hence m = 1) radial basis functions. By keeping
the shape parameter  fixed, the computational error produced by the numerical schemes was measured against the value
of analytical solution or reference solution at specific asset price. In all numerical experiments equispaced grid with ni = 3
is used. In all numerical experiments initial two step are calculated with IMEX-BDF1 method. We used MATLAB R2010 on a
PC with 2.93 GHz Intel(R) Core(TM)i3 CPU and 4.00 GB RAM.

Example 1. European option under Merton model with parameters σ = 0.15, r = 0.05, σ J = 0.45, μ J = −0.90, λ = 0.10,
T = 0.25, K = 100.

These parameters are also used by YongHoon Kwon, and Younhee Lee [19] for pricing European put option with truncated
domain xmin = −1.5 and xmax = 1.5, and by Y. d’Halluin, P.A. Forsythy, and K.R. Vetzal [9] for European call option. The
analytical solution is obtained by using infinite series solution of Merton [23]. The reference values for European put option
are 9.285418 at S = 90, 3.149026 at S = 100, and 1.401186 at S = 110 and for European call option are 0.527638 at S = 90,
4.391246 at S = 100, and 12.643406 at S = 110.
The numerical results for put option and call option are listed in Tables 2 and 3 respectively with shape parameter
 = 3.8. The option value and absolute error are given at different asset prices. From these tables, we can observe that the
discretization scheme is convergent with quadratic rate, since the ratio in respective error is approximately four.
The Greeks help to provide important measurements of an option position’s risks. Greeks are the quantities representing
the sensitivity of the price of derivatives. Delta measures the rate of change of option value with respect to changes in
the underlying asset’s price, where as Gamma represents the rate of change in the delta with respect to changes in the
underlying price. For European put option the reference values of Delta are −0.84671538 at S = 90, −0.35566306 at S =
100, and −0.05810123 at S = 110, and the values of Gamma are 0.03486014 at S = 90, 0.04882567 at S = 100, and
0.01212941 at S = 110. Since radial basis functions are sufficiently smooth it helps us to compute some Greeks like Delta
168 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173

Table 3
Numerical results for European call options under the Merton model at different asset price with parameters as
given in Example 1.

M N S = 90 S = 100 S = 110
Value Error Value Error Value Error
129 25 0.525486 2.1520e–03 4.363028 2.8218e–02 12.638376 5.0297e–03
257 50 0.527113 5.2475e–04 4.384320 6.9262e–03 12.642101 1.3053e–03
513 100 0.527501 1.3655e–04 4.389522 1.7240e–03 12.643072 3.3346e–04
1025 200 0.527604 3.4508e–05 4.390815 4.3054e–04 12.643321 8.5126e–05
2049 400 0.527629 8.7377e–06 4.391138 1.0776e–04 12.643385 2.1274e–05
4097 800 0.527635 2.5525e–06 4.391218 2.7723e–05 12.643400 5.5654e–06

Table 4
Numerical result for Delta of European put options under the Merton model at different asset price with parameters
as given in Example 1.

M N S = 90 S = 100 S = 110
Value Error Value Error Value Error
129 25 −0.847817 1.1019e–03 −0.358125 2.4621e–03 −0.059047 9.4544e–04
257 50 −0.847023 3.0807e–04 −0.356279 6.1556e–04 −0.058334 2.3319e–04
513 100 −0.846794 7.8244e–05 −0.355817 1.5392e–04 −0.058158 5.6766e–05
1025 200 −0.846735 1.9622e–05 −0.355702 3.8482e–05 −0.058115 1.3689e–05
2049 400 −0.846720 4.9210e–06 −0.355673 9.6151e–06 −0.058105 3.4368e–06
4097 800 −0.846717 1.3125e–06 −0.355665 2.3771e–06 −0.058102 8.1211e–07

Table 5
Numerical result for Gamma of European put options under the Merton model at different asset price with param-
eters as given in Example 1.

M N S = 90 S = 100 S = 110
Value Error Value Error Value Error
129 25 0.034448 4.1186e–04 0.049816 9.9002e–04 0.012071 5.8559e–05
257 50 0.034758 1.0225e–04 0.049067 2.4124e–04 0.012117 1.2733e–05
513 100 0.034835 2.5208e–05 0.048886 5.9975e–05 0.012126 3.3105e–06
1025 200 0.034854 6.2791e–06 0.048841 1.4976e–05 0.012129 9.0800e–07
2049 400 0.034859 1.5713e–06 0.048829 3.7404e–06 0.012129 2.2477e–07
4097 800 0.034860 4.1016e–07 0.048827 9.2079e–07 0.012129 6.9091e–08

and Gamma. It has been shown by Sanyasiraju et al. [26] and Wright et al. [32] that RBF-FD approximate first and second
derivative of function with second order accuracy.
Using the same parameter values which is employed for results in Table 2, we computed two Greeks viz Delta and
Gamma at different asset prices and results obtained are reported in Table 4 and 5. From these tables we can observe
that convergence rate of the proposed scheme is quadratic for computing Greeks as well. In Fig. 1 we have plotted the
option values, the Delta and the Gamma. The plot shows that the option values and Greeks are very stable and no spurious
oscillation occur at or around the strike price. These figures show that Greeks are efficiently evaluated using proposed
method.

Example 2. European call option under Merton model with parameters σ = 0.20, r = 0, σ J = 0.50, μ J = 0, λ = 0.10, T = 1.0,
K = 1.

The above parameters are also considered by Bhuruth et al. [25] with truncated domain xmin = −4.0 and xmax = 4.0. In
their article, Bhuruth et al. provided a new radial basis function based differential quadrature approach (RBF-DQ). They first
used RBF-DQ approach for the spatial discretization followed by exponential time integration scheme for time discretization.
Using Merton’s closed form solution, the reference value 0.09413550 at strike price is calculated and the option value and
absolute error at strike price are reported in Table 6 with shape parameter  = 2.2. We observe that the results obtained
with the present method have nice agreement with those given in [5,25].

Example 3. European option under Kou model with parameters σ = 0.15, r = 0.05, η1 = 3.0465, η2 = 3.0775, λ = 0.10,
p = 0.3445, T = 0.25, K = 100.

These parameters are adopted from [19,9]. To perform the numerical simulations, we choose the truncated domain as
xmin = −1.5 and xmax = 1.5. The analytical solution of the model can be found in Kou [18]. The value of European call option
at different asset price are evaluated with six digit after the decimal points by d’Halluin et al. [9]. The reference values for
 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173 169

Fig. 1. European put option value, Delta and Gamma under the Merton model with parameters as provided in the Example 1.

Table 6
Comparison of different methods for European call options under the Merton model at strike price with parameters
as given in Example 2.

M N CM [5] RBF-DQ [25] Present method

Value Error Value Error Value Error
65 5 0.09102 4.01e–03 0.09182 2.32e–03 0.092339 1.7963e–03
129 10 0.09320 9.32e–04 0.93565 5.70e–04 0.093865 2.7096e–04
257 20 0.09413 2.72e–04 0.09399 1.38e–04 0.094076 5.9464e–05
513 40 0.09408 5.39e–05 0.09410 3.02e–05 0.094121 1.4369e–05

call option is 0.672677 at S = 90, 3.973479 at S = 100, and 11.794583 at S = 110. The reference price for put option is
computed using put call parity. The numerical experiment is carried out with shape parameter  = 1.7. From Tables 7 and 8,
we can observe that the point wise error at different asset price decrease, with convergence rate two. Finally in Fig. 2, we
have plotted the option value and Greeks for put option. These figures shows that Greeks are efficiently evaluated under
Kou model as well using proposed method.

Example 4. American put option under the Merton model with parameters σ = 0.15, r = 0.05, σ J = 0.45, μ J = −0.90,
λ = 0.10, T = 0.25, K = 100.

These parameters are consider by d’Halluin, Forsythy, and Labahn [8] and by YongHoon Kwon, and Younhee Lee [20] for
Pricing American put option with truncated domain xmin = −1.5 and xmax = 1.5. In [8] authors have developed an implicit
170 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173

Table 7
Numerical results for European call options under the Kou model at different asset price with parameters as given
in Example 3.

M N S = 90 S = 100 S = 110
Value Error Value Error Value Error
129 25 0.670284 2.3932e–03 3.938910 3.4569e–02 11.787842 6.7414e–03
257 50 0.672105 5.7208e–04 3.964965 8.5136e–03 11.792817 1.7660e–03
513 100 0.672529 1.4783e–04 3.971358 2.1212e–03 11.794129 4.5366e–04
1025 200 0.672639 3.7620e–05 3.972948 5.3113e–04 11.794466 1.1692e–04
2049 400 0.672673 3.9368e–06 3.973363 1.1569e–04 11.794561 2.2399e–05
4097 800 0.672676 1.0867e–06 3.973450 2.9465e–05 11.794577 5.9222e–06

Table 8
Numerical results for European put options under the Kou model at different asset price with parameters as given
in Example 3.

M N S = 90 S = 100 S = 110
Value Error Value Error Value Error
129 25 9.428064 2.3932e–03 2.696690 3.4569e–02 0.545622 6.7413e–03
257 50 9.429885 5.7203e–04 2.722745 8.5135e–03 0.550597 1.7660e–03
513 100 9.430309 1.4778e–04 2.729138 2.1212e–03 0.551909 4.5361e–04
1025 200 9.430419 3.7571e–05 2.730728 5.3108e–04 0.552246 1.1687e–04
2049 400 9.430453 3.8874e–06 2.731143 1.1564e–04 0.552341 2.2349e–05
4097 800 9.430456 1.0373e–06 2.731230 2.9415e–05 0.552357 5.8728e–06

Table 9
Numerical results for American put options under the Merton model at different asset price with parameters as
given in Example 4.

M N S = 90 S = 100 S = 110
Value Error Value Error Value Error
129 25 9.998080 – 3.207266 – 1.414138 –
257 50 10.000259 2.1789e–03 3.232387 2.5120e–02 1.418174 4.0361e–03
513 100 10.003020 2.7610e–03 3.238920 6.5333e–03 1.419327 1.1528e–03
1025 200 10.003934 9.1430e–04 3.240634 1.7132e–03 1.419660 3.3244e–04
2049 400 10.003835 9.9612e–05 3.241085 4.5131e–04 1.419759 9.9174e–05
4097 800 10.003866 3.1405e–05 3.241207 1.2209e–05 1.419790 3.0951e–05

discretization coupled with penalty method for pricing such American options. The authors in [20] developed the three time
level IMEX method coupled with operator splitting method to solve such problems. The option value and error at different
asset price are reported in Table 9 with shape parameter  = 3.8. To obtain error at different asset price in Table 9, we have
computed the successive changes in the option value at each asset price.
From the above table, we observe that point wise errors generally converge with approximately second order accuracy,
while near the optimal exercise boundary convergence is less accurate. The above phenomenon is also discussed in [8,20].
In Fig. 3, we provide the plot of both option values and the early exercise boundary for American put option under the
Merton model.

Example 5. American put option under the Kou model with parameters σ = 0.15, r = 0.05, η1 = 3.0465, η2 = 3.0775,
λ = 0.10, p = 0.3445, T = 0.25, K = 100.

These parameters are also adopted by YongHoon Kwon, and Younhee Lee [20] with same truncated domain and shape
parameter. The reference values at different asset prices are given by Toivanen [29] are 10.005071 at S = 90, 2.807879 at
S = 100, and 0.561876 at S = 110. In Table 10, we get the same scenario as in the case of Merton model. We are getting
approximately second order convergence rate, while we have less accuracy near by the early exercise boundary. Finally in
Fig. 4, we have plotted the option value and early exercise boundary for American put option under Kou model.
Since we are using backward difference method of order two for time semi discretization, and problem have non-smooth
initial condition, we observe that the increasing of ni value does not seem comparably efficient.
Finally cpu times (in seconds) of the method with Merton model for European put option and American put option
(Example 1 and 4) and with Kou model for European put option and American put option (Example 3 and 5) are given in
Table 11.
 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173 171

Fig. 2. European put option value, Delta and Gamma under the Kou model with parameters as provided in the Example 3.

Fig. 3. American put option value, and optimal early exercise boundary under the Merton model with parameters as provided in the Example 4.
172 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173

Table 10
Numerical results for American put options under the Kou model at different asset price with parameters as given
in Example 5.

M N S = 90 S = 100 S = 110
Value Error Value Error Value Error
129 25 10.002131 – 2.777966 – 0.558356 –
257 50 10.000735 1.3951e–03 2.799956 2.1990e–02 0.560726 2.3706e–03
513 100 10.005015 4.2794e–03 2.805766 5.8098e–03 0.561502 7.7560e–04
1025 200 10.005055 3.9945e–05 2.807307 1.5414e–03 0.561750 2.4808e–04
2049 400 10.005088 3.3276e–05 2.807723 4.1541e–04 0.561834 8.3698e–05
4097 800 10.005098 9.4650e–06 2.807834 1.1140e–04 0.561861 2.7201e–05

Fig. 4. American put option value, and optimal early exercise boundary under the Kou model with parameters as provided in the Example 5.

Table 11
CPU times of the proposed methods for different experiment setup.

M N Merton model Kou model

European option American option European option American option
129 25 0.2260 0.2766 0.2192 0.2765
257 50 0.0359 0.0617 0.0512 0.0635
513 100 0.0582 0.0878 0.0648 0.0913
1025 200 0.1602 0.2369 0.1769 0.2492
2049 400 0.5644 0.7946 0.6078 0.8194
4097 800 2.0307 2.7810 2.1449 2.9971

6. Conclusion

In this article, a RBF based method for solving partial integro-differential equations, which arises when underlying asset
follows the jump diffusion process has been presented. After time semi discretization of governing equation, the resulting
linear differential equation is solved using RBF based finite difference method, the integral term involved in PIDE is approx-
imated with composite trapezoidal rule. The numerical simulation with European put/call and American put option under
Merton and Kou model is carried out. The results obtained in this paper are compared with the finite element and radial
basis function based differential quadrature methods, and we observed that the proposed method is more accurate and
efficient. The proposed method approximates not only the option value but also some of its “Greeks” namely “Delta” and
“Gamma” very efficiently.

Acknowledgements

The authors would like to thank the anonymous referees for their valuable comments and suggestion which helped to
improve the presentation of the work. This research work of authors Alpesh Kumar, Lok Pati Tripathi is supported by Council
of Scientific and Industrial Research, India with grant no. 10-2(5)/2007(ii)-E.U.II and 09/092(0715)/2009-EMR-I respectively.
 M.K. Kadalbajoo et al. / Applied Numerical Mathematics 110 (2016) 159–173 173

Appendix A. Supplementary material

Supplementary material related to this article can be found online at http://dx.doi.org/10.1016/j.apnum.2016.08.006.

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