Calibration of Volatility with American Options

Yves Achdou

Abstract: The price of an American option is obtained from the price of the underlying asset by solving a parabolic variational inequality. The free boundary associated with this variational inequality can be interpreted as the price for which the option should be exercised. The calibration of volatility from the observations of the prices of an american option yields an inverse problem for the previously mentioned parabolic variational inequality. After studying the variational inequality and the exercise price, we give results concerning the sensitivity of the option price and of the exercise price with respect to the variations of the volatility. The inverse problem is addressed by a least square method, with suitable regularization terms. Necessary optimality conditions involving an adjoint state are given and the differentiability of the cost function is studied. This programm is implemented numerically and numerical results are given.

This work has been done jointly with Olivier Pironneau from Laboratoire J.L. Lions, Université Pierre et Marie Curie, Boite courrier 187, 75252 Paris Cedex 05. France. Email: pironneau@ann.jussieu.fr