One-Factor-Based Exercise Strategies for American Options in Multi-Factor Models

34 Pages Posted: 24 Sep 2012 Last revised: 2 May 2017

See all articles by Alfredo Ibañez

Alfredo Ibañez

Comillas Pontifical University

Carlos Velasco

Universidad Carlos III de Madrid - Department of Economics

Date Written: April 16, 2017

Abstract

This paper explains the losses (or errors) associated with pricing an American option in a multi-factor setting when using the true model but a suboptimal exercise strategy as a barrier option (a calibrated misspecified model, e.g., Black-Scholes). Pricing American options in a multi-factor setting is so cumbersome that the typical approach is based on reduced, one-factor exercise strategies. We factorize the associated losses as the product of four terms and properly distinguish between a barrier option and Black-Scholes. Pricing losses are significant (i.e., more than two-digit basis points) for in-the-money and mid-/long-term American options in models with a high volatility skew and large interest-rate-to-dividend-yield spreads. Black-Scholes produces half the pricing errors of a barrier option, which go either way.

Keywords: American options, suboptimal exercise, one-factor-based strategies, Black-Scholes model, model errors, optimal-stopping

JEL Classification: G12, G13

Suggested Citation

Ibañez, Alfredo and Velasco, Carlos, One-Factor-Based Exercise Strategies for American Options in Multi-Factor Models (April 16, 2017). Available at SSRN: https://ssrn.com/abstract=2151387 or http://dx.doi.org/10.2139/ssrn.2151387

Alfredo Ibañez (Contact Author)

Comillas Pontifical University ( email )

Alberto Aguilera 21
Madrid, Madrid 28015
Spain

Carlos Velasco

Universidad Carlos III de Madrid - Department of Economics ( email )

Calle Madrid 126
Getafe, 28903
Spain
+34-91 6249646 (Phone)
+34-91 6249875 (Fax)

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