An efficient computational method for solving the fractional form of the European option price PDE with transaction cost under the fractional Heston model

Abstract

This paper introduces a new method for precise option pricing analysis by utilizing the fractional form of the option price partial differential equation (PDE) and implementing a collocation technique based on the first Fermat polynomial sequence. The key innovation of this study is the exploration of the fractional formulation of European option pricing within the context of the fractional Heston model, which employs a collocation scheme utilizing Fermat polynomials to generate operational matrices characterized by numerous zeros, thereby enhancing computational efficiency. To achieve this, we first derive the option price PDE and convert it to its fractional form in the Caputo sense. We then solve the fractional PDE using fractional Fermat functions, expressing the solution as a series of multivariate Fermat functions with unknown coefficients. Following this, we compute the operational matrices for the Caputo fractional derivative and related partial derivatives, demonstrating how this computational framework transforms the primary problem into a nonlinear system of equations. Additionally, we conduct a convergence analysis of the collocation method. We conclude by presenting several numerical examples that illustrate the applicability and effectiveness of the proposed method, with its robust theoretical foundations and successful numerical tests indicating significant potential for practical applications in finance.