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

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  • Ibáñez, Alfredo
  • Zapatero, Fernando

Abstract

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.

Suggested Citation

  • Ibáñez, Alfredo & Zapatero, Fernando, 2004. "Monte Carlo Valuation of American Options through Computation of the Optimal Exercise Frontier," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(2), pages 253-275, June.
  • Handle: RePEc:cup:jfinqa:v:39:y:2004:i:02:p:253-275_00
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