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Rationality Parameter for Exercising American Put

Listed author(s):
  • Kamille Sofie Tågholt Gad

    ()

    (Department of Mathematical Sciences, University of Copenhagen, Universitetsparken 5, 2100 Copenhagen, Denmark)

  • Jesper Lund Pedersen

    ()

    (Department of Mathematical Sciences, University of Copenhagen, Universitetsparken 5, 2100 Copenhagen, Denmark)

Registered author(s):

    In this paper, irrational exercise behavior of the buyer of an American put is characterized by a single parameter. We model irrational exercise rules as the first jump time of a point processes with stochastic intensity. By the rationality parameter, we parameterize a family of stochastic intensities that depends on the value of the put itself. We present a probabilistic proof that the value of the American put using the irrational exercise rule converges to the arbitrage-free price as the rationality parameter converges to infinity. Another application of this result is the penalty method for approximating the price of an American put.

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    Article provided by MDPI, Open Access Journal in its journal Risks.

    Volume (Year): 3 (2015)
    Issue (Month): 2 (May)
    Pages: 1-9

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    Handle: RePEc:gam:jrisks:v:3:y:2015:i:2:p:103-111:d:49867
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    1. Chen, Hsiao-Chi & Friedman, James W. & Thisse, Jacques-Francois, 1997. "Boundedly Rational Nash Equilibrium: A Probabilistic Choice Approach," Games and Economic Behavior, Elsevier, vol. 18(1), pages 32-54, January.
    2. Allen M. Poteshman & Vitaly Serbin, 2003. "Clearly Irrational Financial Market Behavior: Evidence from the Early Exercise of Exchange Traded Stock Options," Journal of Finance, American Finance Association, vol. 58(1), pages 37-70, 02.
    3. Dai, Min & Kwok, Yue Kuen & You, Hong, 2007. "Intensity-based framework and penalty formulation of optimal stopping problems," Journal of Economic Dynamics and Control, Elsevier, vol. 31(12), pages 3860-3880, December.
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