New Bounds on American Option Prices

Abstract

In this article, we develop new upper and lower bounds on American option prices which improve the bounds by Broadie and Detemple. The main idea is the consideration of doubly capped call options which have two cap prices. We present a new option price approximation based on the two upper bounds. On average, our upper bound extrapolation (named UBE) has an average accuracy better than a 1,000 time-step binomial tree with a computation speed comparable to a 100 time-step binomial tree. We also provide a new method of approximating the optimal exercise boundaries of American options.

Keywords: American option, Optimal exercise boundary, Approximation, Bound, Cap

JEL Classification: G13