Computational Efficiency and Accuracy in the Valuation of Basket Options
The complexity involved in the pricing of American style basket options requires careful consideration of both computational efficiency and accuracy. The conventional assumption of lognormal distribution for the value of a basket is the key for the trade-off. This paper examines the mispricing errors of Bermudan basket options based on the assumption. The mispricing error is measured by the price differences between the price resulting from the assumption of lognormal distribution and the "true" option price. The "true" option prices are obtained from simulation based on procedure described in Longstaff and Schwartz (2001). The effects on the maturities, the volatilities, the correlations, the dividend payments for the underlying assets, number of underlying assets in the basket and the "moneyness" on mispricing are addressed.
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