Monotone methods in counterparty risk models with nonlinear Black–Scholes-type equations

Abstract

AbstractA nonlinear Black–Scholes-type equation is studied within counterparty risk models. The classical hypothesis on the uniform Lipschitz-continuity of the nonlinear reaction function allows for an equivalent transformation of the semilinear Black–Scholes equation into a standard parabolic problem with a monotone nonlinear reaction function and an inhomogeneous linear diffusion equation. This setting allows us to construct a scheme of monotone, increasing or decreasing, iterations that converge monotonically to the true solution. As typically any numerical solution of this problem uses most computational power for computing an approximate solution to the inhomogeneous linear diffusion equation, we discuss also this question and suggest several solution methods, including those based on Monte Carlo and finite differences/elements.