Pricing American Commodity Options Under the Schwartz Two-Factor Model Using the Alternating Direction Explicit (ADE) Method
Sanjith Prabhu, Daniel J. Duffy
Abstract
This project investigates the valuation of American commodity options using the Schwartz two-factor model. We employ the double-sweep Alternating Direction Explicit (ADE) method, an unconditionally stable (for diffusion) finite difference scheme that provides the efficiency of explicit marching with the stability typically reserved for implicit methods, and compare it with the single-sweep alternating variant of Saul'yev. We derive the governing partial differential equation (PDE) and transform the semi-infinite domain into a rectangular computational domain. Furthermore, we apply Fichera theory to determine boundary conditions at the limits of the spot price. Finally, we implement the solver in C++, validating the results first against the closed-form solution of the PDE and Monte Carlo as a European option, then apply the American early exercise constraint and benchmark against Longstaff-Schwartz Monte Carlo to analyze numerical accuracy and convergence. The framework is then extended, following feedback from a commodities trader to exercise on futures prices and use seasonal parameters.
Read the AI summary and key takeaways for traders on WOBR Quant Research.