Entropic Least-Squares Valuation of American Options Subject to Moment Constraints

62 Pages Posted: 22 Aug 2011 Last revised: 30 Dec 2018

See all articles by Xisheng Yu

Xisheng Yu

Southwestern University of Finance and Economics (SWUFE)

Li Yang

UNSW Australia Business School, School of Banking and Finance; Financial Research Network (FIRN)

Date Written: December 5, 2012

Abstract

We propose a new nonparametric method for valuing American options. We extract the risk neutral moments using a set of option data and incorporate them into the entropy framework as constraints to recover the risk-neutral pricing measure. With the recovered risk-neutral measure, we generate paths of the underlying asset returns and determine the optimal exercising strategies via the least-squares algorithm of Longstaff and Schwartz (2001).

The results, based on simulations and the IBM option contracts, demonstrate that our method consistently outperforms several alternative methods. Implementation of our method is simple and straightforward.

Keywords: Risk neutral moments; Maximum entropy; Risk neutral measure; least-squares Monte Carlo; American option pricing

Suggested Citation

Yu, Xisheng and Yang, Li, Entropic Least-Squares Valuation of American Options Subject to Moment Constraints (December 5, 2012). 24th Australasian Finance and Banking Conference 2011 Paper. Available at SSRN: https://ssrn.com/abstract=1914245 or http://dx.doi.org/10.2139/ssrn.1914245

Xisheng Yu

Southwestern University of Finance and Economics (SWUFE) ( email )

55 Guanghuacun St,
Chengdu, Sichuan 610074
China

Li Yang (Contact Author)

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia
+610293855857 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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