Numerical simulation for European and American option of risks in climate change of Three Gorges Reservoir Area

Abstract With the climate change processes over times, all professions and trades in Three Gorges Reservoir Area will be influenced. One of the biggest challenges is the risk of rising sea level. In this situation, a large number of uncertainties for climate changes will be faced in Three Gorges Reservoir Area. Therefore, it is of importance to investigate the complexity of decision making on investing in the long term rising sea level risk related projects in Three Gorges Reservoir Area. This paper investigates the sea level and the temperature as the underlying assets in Three Gorges Reservoir Area. A real option model is constructed to evaluate potential sea level rising risk. We formulate European and American real option models into a linear parabolic variational inequalities and propose a power penalty approach to solve it. Then we obtain a nonlinear parabolic equation. It shows that the nonlinear parabolic equation is unique and solvable. Also, the solutions of the nonlinear parabolic equation converge to the solutions of the parabolic variational inequalities at the rate of order O(λ−k/2). Since the analytic solution of nonlinear parabolic equation is difficult to obtain, a fitted finite volume method is developed to solve it in case of European and American options, and the convergence of the nonlinear parabolic equation is obtained. An empirical analysis is presented to illustrate our theoretical results.