A systematic approach for valuing American-style installment options with continuous payment plan
AbstractIn this paper we present an integral equation approach for the valuation of American-style installment derivatives when the premium payments, made continuously throughout the contract’s life, are assumed to be a function of the asset price and time. The contribution of this study is three-fold. First, we show that in the Black-Scholes framework the option pricing problem can be formulated as a free boundary problem under very general conditions on payo structure and payment plan. Second, by applying a Fourier transform-based solution technique, we derive two recursive integral equations for the free boundaries along with an analytic representation for the option price. Third, within this systematic treatment of the American installment options, we propose a unified and easily applicable method to deal with a wide range of monotonic payo functions and continuous payment plans. Finally, by using the illustrative example of American vanilla installment call options, an explicit pricing formula is obtained for payment schedules depending on the time only.
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Bibliographic InfoPaper provided by Department of Economics - University Roma Tre in its series Departmental Working Papers of Economics - University 'Roma Tre' with number 0120.
Date of creation: Sep 2010
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Installment options; free boundary problem; incomplete Fourier transforms; integral representations;
Find related papers by JEL classification:
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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