A New Spectral Element Method for Pricing European Options Under the Black–Scholes and Merton Jump Diffusion Models

Abstract

We present a new spectral element method for solving partial integro-differential equations for pricing European options under the Black-Scholes and Merton jump diffusion models. Our main contributions are: (i) using an optimal set of orthogonal polynomial bases to yield banded linear systems and to achieve spectral accuracy; (ii) using Laguerre functions for the approximations on the semi-infinite domain, to avoid the domain truncation; and (iii) deriving a rigorous proof of stability for the time discretizations of European put options under both the Black-Scholes model and the Merton jump diffusion model. The new method is flexible for handling different boundary conditions and non-smooth initial conditions for various contingent claims. Numerical examples are presented to demonstrate the efficiency and accuracy of the new method.

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