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Pricing an American Option by Approximating Its Early Exercise Boundary as a Multipiece Exponential Function

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  • Ju, Nengjiu

Abstract

This article proposes to price an American option by approximating its early exercise boundary as a multipiece exponential function. Closed form formulas are obtained in terms of the bases and exponents of the multipiece exponential function. It is demonstrated that a three-point extrapolation scheme has the accuracy of an 800-time-step binomial tree, but is about 130 times faster. An intuitive argument is given to indicate why this seemingly crude approximation works so well. Our method is very simple and easy to implement. Comparisons with other leading competing methods are also included. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Suggested Citation

  • Ju, Nengjiu, 1998. "Pricing an American Option by Approximating Its Early Exercise Boundary as a Multipiece Exponential Function," Review of Financial Studies, Society for Financial Studies, vol. 11(3), pages 627-646.
  • Handle: RePEc:oup:rfinst:v:11:y:1998:i:3:p:627-46
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