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A Quasi-analytical Interpolation Method for Pricing American Options under General Multi-dimensional Diffusion Processes

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  • Li, Minqiang

Abstract

We present a quasi-analytical method for pricing multi-dimensional American options based on interpolating two arbitrage bounds, along the lines of Johnson (1983). Our method allows for the close examination of the interpolation parameter on a rigorous theoretical footing instead of empirical regression. The method can be adapted to general diffusion processes as long as quick and accurate pricing methods exist for the corresponding European and perpetual American options. The American option price is shown to be approximately equal to an interpolation of two European option prices with the interpolation weight proportional to a perpetual American option. In the Black-Scholes model, our method achieves the same e±ciency as Barone-Adesi and Whaley's (1987) quadratic approximation with our method being generally more accurate for out-of-the-money and long-maturity options. When applied to Heston's stochastic volatility model, our method is shown to be extremely e±cient and fairly accurate.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 17348.

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Date of creation: 2009
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Handle: RePEc:pra:mprapa:17348

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Keywords: American option; Interpolation method; Quasi-analytical approximation; Critical bound- ary; Heston's Stochastic volatility model;

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