Nontraded asset valuation with portfolio constraints: a binomial approach |
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Authors: | Detemple J; Sundaresan S |
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Institution: | McGill University and CIRANO, Canada
Columbia University, USA
Correspondence to: J Detemple, Faculty of Management, McGill University, 1001 Sherbrooke Street West, Montral, Quebec, Canada H3A 1G5
e-mail: detemple@management.mcgill.ca |
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Abstract: | We provide a simple binomial framework to value American-stylederivatives subject to trading restrictions. The optimal investmentof liquid wealth is solved simultaneously with the early exercisedecision of the nontraded derivative. No-short-sales constraintson the underlying asset manifest themselves in the form of animplicit dividend yield in the risk-neutralized process forthe underlying asset. One consequence is that American calloptions may be optimally exercised prior to maturity even whenthe underlying asset pays no dividends. Applications to executivestock options (ESO) are presented: it is shown that the valueof an ESO could be substantially lower than that computed usingthe Black-Scholes model. We also analyze nontraded payoffs basedon a price that is imperfectly correlated with the price ofa traded asset. |
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