An interior penalty method for a parabolic complementarity problem involving a fractional Black-Scholes operator

Abstract

Abstract In this paper, an interior penalty method is proposed to solve a parabolic complementarity problem involving fractional Black–Scholes operator arising in pricing American options under a geometric Lévy process. The complementarity problem is first reformulated as a fractional partial differential variational inequality problem using the representations of fractional order operators and appropriate mathematical techniques. A penalty equation is then proposed to approximate the variational inequality problem by introducing a novel interior-point based penalty term. The existence and uniqueness of the solution to the penalized problem are proved, and an upper bound on the distance between the solutions to the penalty equation and the variational inequality problem is established. To test our method, we discretize the penalty equation by a finite difference method in space and the Crank–Nicolson method in time. We then present numerical experimental results to demonstrate the usefulness and effectiveness for the interior penalty method.

Keywords

• Complementarity problem
• Interior penalty method
• Fractional Black–Scholes operator
• Finite difference method
• American option valuation