American option valuation under stochastic interest rates

By applying Ho, Stapleton and Subrahmanyam's (1997, hereafter HSS) generalised Geske–Johnson (1984, hereafter GJ) method, this paper provides analytic solutions for the valuation and hedging of American options in a stochastic interest rate economy. The proposed method simplifies HSS's three-dimensional solution to a one-dimensional solution. The simulations verify that the proposed method is more efficient and accurate than the HSS (1997) method. We illustrate how the price, the delta, and the rho of an American option vary between the stochastic and non-stochastic interest rate models. The magnitude of this effect depends on the moneyness of the option, interest rates, volatilities of the underlying asset price and the bond price, as well as the correlation between them. This revised version was published online in June 2006 with corrections to the Cover Date.