Pricing and Hedging American-Style Options: A Simple Simulation-Based Approach

The Journal of Computational Finance (95-125), Volumn 13 / Number 4, Summer 2010.

29 Pages Posted: 21 Oct 2009 Last revised: 13 Aug 2012

See all articles by Yang Wang

Yang Wang

University of California, Los Angeles (UCLA) - Department of Mathematics

Russel Caflisch

University of California, Los Angeles (UCLA) - Department of Mathematics

Date Written: July 22, 2009

Abstract

This article presents a simple yet powerful simulation-based approach for approximating the values of prices and Greeks (i.e. derivatives with respect to the underlying spot prices, such as delta, gamma, etc) for American-style options. This approach is primarily based upon the Least Squares Monte Carlo (LSM) algorithm and is thus termed the Modified LSM (MLSM) algorithm. The key to this approach is that with initial asset prices randomly generated from a carefully chosen distribution, we obtain a regression equation for the initial value function, which can be differentiated analytically to generate estimates for the Greeks. Our approach is intuitive, easy to apply, computationally efficient and most importantly, provides a unified framework for estimating risk sensitivities of the option price to underlying spot prices. We demonstrate the effectiveness of this technique with a series of increasingly complex but realistic examples.

Keywords: American option, Simulation-based Approach, Least Squares Monte-Carlo, Pricing and Hedging, Estimating Sensitivities

Suggested Citation

Wang, Yang and Caflisch, Russel, Pricing and Hedging American-Style Options: A Simple Simulation-Based Approach (July 22, 2009). The Journal of Computational Finance (95-125), Volumn 13 / Number 4, Summer 2010.. Available at SSRN: https://ssrn.com/abstract=1491686

Yang Wang (Contact Author)

University of California, Los Angeles (UCLA) - Department of Mathematics ( email )

Los Angeles, CA 90095-1481
United States

Russel Caflisch

University of California, Los Angeles (UCLA) - Department of Mathematics ( email )

Los Angeles, CA 90095-1481
United States

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