Valuing American Options Using Fast Recursive Projections
69 Pages Posted: 25 Jun 2012 Last revised: 7 Dec 2018
Date Written: March 2, 2016
We introduce a fast and widely applicable numerical pricing method that uses recursive projections. We characterize its convergence speed. We find that the early exercise boundary of an American call option on a discrete dividend paying stock is higher under the Merton and Heston models than under the Black-Scholes model, as opposed to the continuous dividend case. A large database of call options on stocks with quarterly dividends shows that adding stochastic volatility and jumps to the Black-Scholes benchmark reduces the amount foregone by call holders failing to optimally exercise by 25\%. Transaction fees cannot fully explain the suboptimal behavior.
Keywords: Option pricing, American option, Bermudan option, discrete transform, discrete dividend paying stock, suboptimal non-exercise, numerical techniques
JEL Classification: G13, C63
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