AN INVESTIGATION ON NONLINEAR OPTION PRICING BEHAVIOURS THROUGH A NEW FRÉCHET DERIVATIVE-BASED QUADRATURE APPROACH

Abstract Complicated option pricing models attract much attention in financial industries, as they produce relatively better accurate values by taking into account more realistic assumptions such as market liquidity, uncertain volatility and so forth. We propose a new hybrid method to accurately explore the behaviour of the nonlinear pricing model in illiquid markets, which is important in financial risk management. Our method is based on the Newton iteration technique and the Fréchet derivative to linearize the model. The linearized equation is then discretized by a differential quadrature method in space and a quadratic trapezoid rule in time. It is observed through computations that the accurate solutions for the model emerge using very few grid points and time elements, compared with the finite difference method in the literature. Furthermore, this method also helps to avoid consideration of the convergence issues of the Newton approach applied to the nonlinear algebraic system containing many unknowns at each time step if an implicit method is used in time discretization. It is important to note that the Fréchet derivative supports to enhance the convergence order of the proposed iterative scheme.