One-Factor-Based Exercise Strategies for American Options in Multi-Factor Models
34 Pages Posted: 24 Sep 2012 Last revised: 2 May 2017
Date Written: April 16, 2017
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: Suggested Citation