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Pricing American Options Using a Nonparametric Entropy Approach

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  • Xisheng Yu
  • Li Yang

Abstract

This paper studies the pricing problem of American options using a nonparametric entropy approach. First, we derive a general expression for recovering the risk-neutral moments of underlying asset return and then incorporate them into the maximum entropy framework as constraints. Second, by solving this constrained entropy problem, we obtain a discrete risk-neutral (martingale) distribution as the unique pricing measure. Third, the optimal exercise strategies are achieved via the least-squares Monte Carlo algorithm and consequently the pricing algorithm of American options is obtained. Finally, we conduct the comparative analysis based on simulations and IBM option contracts. The results demonstrate that this nonparametric entropy approach yields reasonably accurate prices for American options and produces smaller pricing errors compared to other competing methods.

Suggested Citation

  • Xisheng Yu & Li Yang, 2014. "Pricing American Options Using a Nonparametric Entropy Approach," Discrete Dynamics in Nature and Society, Hindawi, vol. 2014, pages 1-16, May.
    • Handle: RePEc:hin:jnddns:369795
    DOI: 10.1155/2014/369795
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    Cited by:

    1. Yu, Xisheng, 2021. "A unified entropic pricing framework of option: Using Cressie-Read family of divergences," The North American Journal of Economics and Finance, Elsevier, vol. 58(C).

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