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Monte Carlo Valuation of American Options through Computation of the Optimal Exercise Frontier

  • Ibáñez, Alfredo
  • Zapatero, Fernando

This paper introduces a Monte Carlo simulation method for pricing multidimensional American options based on the computation of the optimal exercise frontier. We consider Bermudan options that can be exercised at a finite number of times and compute the optimal exercise frontier recursively. We show that for every date of possible exercise, any single point of the optimal exercise frontier is a fixed point of a simple algorithm. Once the frontier is computed, we use plain vanilla Monte Carlo simulation to price the option and obtain a low-biased estimator. We illustrate the method with applications to several types of options.

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Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 39 (2004)
Issue (Month): 02 (June)
Pages: 253-275

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Handle: RePEc:cup:jfinqa:v:39:y:2004:i:02:p:253-275_00
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