Pricing Installment Options with an Application to Asx Installment Warrants

Abstract

Installment options are Bermudan-style options where the holder periodically decides whether to exercise or not and then to keep the option alive or not (by paying the installment). We develop a dynamic programming procedure to price installment options. We derive the range of installments within which the installment option is not redundant with the European contract. Simulations analysis shows the method yields monotonically converging prices, and satisfactory trade-offs between accuracy and computational time. In addition, we examine the flexibility in installment option design that yields various hedging properties. Our approach is applied to installment warrants, which are actively traded on the Australian Stock Exchange. Numerical investigation shows the various capital dilution effects resulting from different installment warrant designs.

Keywords: Option Pricing, Exotic Options, Dynamic Programming, Installment Options

JEL Classification: C63, G13