Value Function Approximation or Stopping Time Approximation: A Comparison of Two Recent Numerical Methods for American Option Pricing using Simulation and Regression

48 Pages Posted: 12 Dec 2008 Last revised: 26 Apr 2012

See all articles by Lars Stentoft

Lars Stentoft

Department of Economics, University of Western Ontario; Center for Interuniversity Research and Analysis on Organization (CIRANO); Aarhus University - CREATES

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Date Written: December 12, 2008

Abstract

In Longstaff and Schwartz (2001) a method for American option pricing using simulation and regression is suggested, and since then the method has rapidly gained importance. However, the idea of using regression and simulation for American option pricing was used at least as early as in Carriere (1996). In the present paper we provide a thorough comparison of these two methods and relate them to the work of Tsitsiklis and Van Roy (2001). Although the methods are often considered to be similar this analysis allows us to point out an important but often overlooked difference between the methods. The paper further shows that due to this difference it is possible to provide arguments favoring the method suggested in Longstaff and Schwartz (2001). Finally, the paper compares the methods in a realistic numerical setting and shows that the practitioner does well in choosing the method of Longstaff and Schwartz (2001) instead of the methods of Carriere (1996) or Tsitsiklis and Van Roy (2001) for American option pricing.

Keywords: American Options, Least Squares Regression, Monte Carlo Simulation, Optimal Stopping Time Iteration, Value Function Iteration

JEL Classification: C15, G12, G13

Suggested Citation

Stentoft, Lars, Value Function Approximation or Stopping Time Approximation: A Comparison of Two Recent Numerical Methods for American Option Pricing using Simulation and Regression (December 12, 2008). Available at SSRN: https://ssrn.com/abstract=1315306 or http://dx.doi.org/10.2139/ssrn.1315306

Lars Stentoft (Contact Author)

Department of Economics, University of Western Ontario ( email )

London, Ontario N6A 5B8
Canada

Center for Interuniversity Research and Analysis on Organization (CIRANO)

2020 rue University, 25th floor
Montreal H3C 3J7, Quebec
Canada

Aarhus University - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

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