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Evaluation of American Strangles

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Abstract

This paper presents a generalisation of McKean's free boundary value problem for American options by considering an American strangle position, where the early exercise of one side of the payoff will knock-out the out-of-the-money side. When attempting to evaluate the price of this American strangle, it is not correct to simply price the component American call and put options which make up the strangle, and take the sum of their values. The Fourier transform technique is used to derive the integral equation for the price of our American strangle. From this expression, a coupled integral equation system for the strangle's call- and put-side free boundaries is found. While the equation for the price of the strangle is simply the sum of its component American call and put option equations, the free boundary for each side is shown to have a more complex nature. Anumerical algorithm for solving the coupled integral equation system for the free boundaries is provided, and the resulting approximations are used to determine the price of the American strangle position. Numerical comparisons between the strangle price and the price of a portfolio formed from a long position in both an American call an American put option are presented.

Suggested Citation

  • Carl Chiarella & Andrew Ziogas, 2002. "Evaluation of American Strangles," Research Paper Series 83, Quantitative Finance Research Centre, University of Technology, Sydney.
  • Handle: RePEc:uts:rpaper:83
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    References listed on IDEAS

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    1. Ho, T S & Stapleton, Richard C & Subrahmanyam, Marti G, 1997. " The Valuation of American Options with Stochastic Interest Rates: A Generalization of the Geske-Johnson Technique," Journal of Finance, American Finance Association, vol. 52(2), pages 827-840, June.
    2. Andrew Ziogas & Carl Chiarella, 2003. "McKean’s Method applied to American Call Options on Jump-Diffusion Processes," Computing in Economics and Finance 2003 39, Society for Computational Economics.
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    9. Carl Chiarella & Adam Kucera & Andrew Ziogas, 2004. "A Survey of the Integral Representation of American Option Prices," Research Paper Series 118, Quantitative Finance Research Centre, University of Technology, Sydney.
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    15. Broadie, Mark & Detemple, Jerome, 1995. "American Capped Call Options on Dividend-Paying Assets," Review of Financial Studies, Society for Financial Studies, vol. 8(1), pages 161-191.
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    Cited by:

    1. Andrew Ziogas & Carl Chiarella, 2003. "McKean’s Method applied to American Call Options on Jump-Diffusion Processes," Computing in Economics and Finance 2003 39, Society for Computational Economics.
    2. Detemple, Jérôme & Emmerling, Thomas, 2009. "American chooser options," Journal of Economic Dynamics and Control, Elsevier, vol. 33(1), pages 128-153, January.
    3. Jun Cheng & Jin Zhang, 2012. "Analytical pricing of American options," Review of Derivatives Research, Springer, vol. 15(2), pages 157-192, July.
    4. Andrew Ziogas & Carl Chiarella, 2004. "Pricing American Options on Jump-Diffusion Processes using Fourier-Hermite Series Expansions," Computing in Economics and Finance 2004 177, Society for Computational Economics.
    5. Tomas Bokes, 2010. "A unified approach to determining the early exercise boundary position at expiry for American style of general class of derivatives," Papers 1012.0348, arXiv.org, revised Mar 2011.
    6. Franck Moraux, 2009. "On perpetual American strangles," Post-Print halshs-00393811, HAL.
    7. Carl Chiarella & Jonathan Ziveyi, 2014. "Pricing American options written on two underlying assets," Quantitative Finance, Taylor & Francis Journals, vol. 14(3), pages 409-426, March.
    8. Anna Battauz & Marzia De Donno & Alessandro Sbuelz, 2015. "Real Options and American Derivatives: The Double Continuation Region," Management Science, INFORMS, vol. 61(5), pages 1094-1107, May.
    9. Laminou Abdou, Souleymane & Moraux, Franck, 2016. "Pricing and hedging American and hybrid strangles with finite maturity," Journal of Banking & Finance, Elsevier, vol. 62(C), pages 112-125.
    10. Jérôme Detemple, 2014. "Optimal Exercise for Derivative Securities," Annual Review of Financial Economics, Annual Reviews, vol. 6(1), pages 459-487, December.
    11. Jonathan Ziveyi, 2011. "The Evaluation of Early Exercise Exotic Options," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 12, November.
    12. Mahayni, Antje & Schoenmakers, John G.M., 2011. "Minimum return guarantees with fund switching rights—An optimal stopping problem," Journal of Economic Dynamics and Control, Elsevier, vol. 35(11), pages 1880-1897.
    13. Carl Chiarella & Adam Kucera & Andrew Ziogas, 2004. "A Survey of the Integral Representation of American Option Prices," Research Paper Series 118, Quantitative Finance Research Centre, University of Technology, Sydney.

    More about this item

    Keywords

    american options; volterra integral equation; free-bondary problem;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory

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