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Valuation of American options in the presence of event risk

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  • Alex Szimayer

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Abstract

This paper studies the valuation of American options in the presence of external/non-hedgeable event risk. When the event occurs, the American option is terminated and a rebate is paid instead of the promised pay-off profile. Consequently, the presence of event risk influences the exercise strategy of the option holder. For the financial market in a diffusion setting, the probabilistic structure in terms of equivalent martingale measures is briefly analysed. Then, for a given equivalent martingale measure the optimal stopping problem of the American option is solved. As a main result, no-arbitrage bounds for American option values in the presence of event risk are derived, as well as hedging strategies corresponding to the no-arbitrage bounds. Copyright Springer-Verlag Berlin/Heidelberg 2005

Suggested Citation

  • Alex Szimayer, 2005. "Valuation of American options in the presence of event risk," Finance and Stochastics, Springer, vol. 9(1), pages 89-107, January.
  • Handle: RePEc:spr:finsto:v:9:y:2005:i:1:p:89-107
    DOI: 10.1007/s00780-004-0141-8
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    File URL: http://hdl.handle.net/10.1007/s00780-004-0141-8
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    Cited by:

    1. 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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    Keywords

    American options; Israeli options; event risk;

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