Financial Applications of Symbolically Gener- ated Compact Finite Difference Formulae

We introduce the standard fourth order compact finite difference formulae. We show how these formulae apply in the special case of the heat equation. It is well known that the American option pricing problem may be formulated in terms of the Black Scholes partial differential equation (PDE) together with a free boundary condition. Standard methods allow this problem to be transformed into a moving boundary heat equation problem. We use the compact finite difference method to reduce this problem to a system of ordinary differential equations with specified initial conditions. We develop three ways of combining the resulting systems with methods designed to cope with free boundary values. We show that the compact finite difference scheme for the heat equation and for the American options pricing problem are unconditionally stable. After numerical comparison of these methods with a standard Crank Nicholson projected Successive Over Relaxation method, we conclude that the compact finite difference technique respresents an exciting new method for pricing American options.