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An improved method for pricing and hedging long dated American options

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  • Fabozzi, Frank J.
  • Paletta, Tommaso
  • Stanescu, Silvia
  • Tunaru, Radu

Abstract

The majority of quasi-analytic pricing methods for American options are efficient near maturity but are prone to larger errors when time-to-maturity increases. We introduce a new methodology to increase the accuracy of almost any existing quasi-analytic approach in pricing long-maturity American options. The new methodology, called the “extension-method”, relies on an approximation of the optimal exercise price near the beginning of the contract combined with existing pricing approaches so that the maturity range for which small errors are attainable is extended. Our method retains the quasi-analytic nature of the methods it improves. Generic quasi-analytic formulae for the price of an American put as well as for its hedging parameter are derived. Our scenarios-based numerical study indicates that our method considerably improves both the pricing and the hedging performance of a number of established approaches for a wide range of maturities. The superiority of this approach is illustrated with real financial data by considering S&P 100TM LEAPS® options traded from January 2008 to May 2015.

Suggested Citation

  • Fabozzi, Frank J. & Paletta, Tommaso & Stanescu, Silvia & Tunaru, Radu, 2016. "An improved method for pricing and hedging long dated American options," European Journal of Operational Research, Elsevier, vol. 254(2), pages 656-666.
    • Handle: RePEc:eee:ejores:v:254:y:2016:i:2:p:656-666
    DOI: 10.1016/j.ejor.2016.04.002
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    3. Qianru Shang & Brian Byrne, 2021. "American option pricing: Optimal Lattice models and multidimensional efficiency tests," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(4), pages 514-535, April.
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    6. McGee, Richard J. & McGroarty, Frank, 2017. "The risk premium that never was: A fair value explanation of the volatility spread," European Journal of Operational Research, Elsevier, vol. 262(1), pages 370-380.
    7. Fabozzi, Frank J. & Paletta, Tommaso & Tunaru, Radu, 2017. "An improved least squares Monte Carlo valuation method based on heteroscedasticity," European Journal of Operational Research, Elsevier, vol. 263(2), pages 698-706.
    8. Cristina Viegas & José Azevedo-Pereira, 2020. "A Quasi-Closed-Form Solution for the Valuation of American Put Options," IJFS, MDPI, vol. 8(4), pages 1-16, October.

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