Valuation and Optimal Exercise of Derivatives under Private Information

Abstract

We provide an easy-to-use model that values derivatives for a privately informed agent. We introduce private forward prices that conveniently format private information for inclusion in a standard no-arbitrage framework. This framework yields simple expressions for the privately-informed value of European options. We show that flexible timing of American option exercise can be used to mitigate adverse information or exploit favorable information. Private information may thus cause significant differences between European and American call values, even in the absence of dividends.

Keywords: options, optimal exercise, asymmetric information

JEL Classification: D82, G12, G13