An Improved Method for Pricing and Hedging American Options

45 Pages Posted: 25 Oct 2014 Last revised: 16 Nov 2014

See all articles by Tommaso Paletta

Tommaso Paletta

University of Kent - Kent Business School

Silvia Stanescu

University of Kent - Kent Business School

Radu Tunaru

University of Sussex

Date Written: October 24, 2014

Abstract

The majority of quasi-analytic pricing methods for American options are efficient near-maturity but are prone to larger errors when time-to-maturity increases. A new methodology, called the "extension"-method, is introduced to increase the accuracy of almost any existing quasi-analytic approach in pricing long-maturity American options. It relies on an approximation of the optimal exercise price near the beginning of the contract combined with existing pricing approaches so that the maturity range for which small errors are attainable is extended. The new methodology retains the quasi-analytic nature of the methods it improves on and we derive generic quasi-analytic formulae for the price of an American put as well as for its delta parameter. Our numerical study indicates that the proposed methodology considerably improves both the pricing and the hedging performance of a number of established approaches for a wide range of maturities. Furthermore, the pricing improvements are most sizeable at longer maturities, where existing approaches do not perform well.

Keywords: American options, Optimal exercise price, Quasi-analytic method, Delta-Hedging performance

JEL Classification: G13, C63

Suggested Citation

Paletta, Tommaso and Stanescu, Silvia and Tunaru, Radu, An Improved Method for Pricing and Hedging American Options (October 24, 2014). Available at SSRN: https://ssrn.com/abstract=2514504 or http://dx.doi.org/10.2139/ssrn.2514504

Tommaso Paletta

University of Kent - Kent Business School ( email )

Canterbury, Kent CT2 7PE
United Kingdom

Silvia Stanescu

University of Kent - Kent Business School ( email )

Canterbury, Kent CT2 7PE
United Kingdom

Radu Tunaru (Contact Author)

University of Sussex ( email )

Jubilee
Brighton, BN1 9SL
United Kingdom

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