Confined exponential approximations for the valuation of American options |
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Authors: | Jongwoo Lee Dean A Paxson |
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Institution: | 1. Korean Federation of Community Credit Cooperatives , 164 Samsung-Dong, Kangnam-Ku, Seoul, Korea , 135-090;2. Manchester Business School , Booth Street West, Manchester, UK , M15 6PB |
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Abstract: | We provide an alternative analytic approximation for the value of an American option using a confined exponential distribution with tight upper bounds. This is an extension of the Geske and Johnson compound option approach and the Ho et al. exponential extrapolation method. Use of a perpetual American put value, and then a European put with high input volatility is suggested in order to provide a tighter upper bound for an American put price than simply the exercise price. Numerical results show that the new method not only overcomes the deficiencies in existing two-point extrapolation methods for long-term options but also further improves pricing accuracy for short-term options, which may substitute adequately for numerical solutions. As an extension, an analytic approximation is presented for a two-factor American call option. |
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Keywords: | confined exponential distribution analytical approximations tight upper bounds two-factor American option |
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