Some mathematical results in the pricing of American options

Abstract

We examine the Black–Scholes partial differential equation for the pricing of a traded option (an American call option on an asset paying a continuous dividend) and make comparisons with other well known free boundary diffusion problems, such as the oxygen consumption problem. The pricing of American options can be viewed as a free boundary problem and is, therefore, inherently nonlinear. We consider the short and long time behaviour of the free boundary, present analytic results for the option value in such limits, and consider the formulation of the problem as a variational inequality, and its numerical solution.