FoundationMultiple choice
Stepping the heat equation · Part 1 of 3
You price a European option by transforming the Black–Scholes equation into the heat equation and stepping it on a grid with spacing and time step . Write .
With the explicit forward-Euler scheme you choose . What do you see?
- AA sawtooth that grows from step to step until the prices are garbage
- BA stable solution, slightly less accurate than at 0.4, since larger steps simply carry more truncation error
- CA smooth solution that converges to a slightly wrong price
- DNothing unusual, because λ is below 1
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