American Option Pricing and Exercising with Transaction Costs
Norwegian School of Economics and Business Administration Discussion Paper No. 15/2003
40 Pages Posted: 15 Feb 2010
Date Written: November 1, 2003
In this paper we examine the problem of finding the reservation option prices and corresponding exercise policies of American options in a market with proportional transaction costs using the utility based approach proposed by Davis and Zariphopoulou (1995). We present a model where the option holder has a constant absolute risk aversion. We discuss the numerical algorithm and propose a new characterization of the option holder's value function. We suggest original discretization schemes for computing reservation prices and exercise policies of American options. The discretization schemes are implemented for the cases of American put and call options. We present the study of the optimal transaction policy of the option holder. We examine the effects on the reservation option prices and the corresponding exercise policies of varying the levels of absolute risk aversion and transaction costs.
Keywords: option pricing, transaction costs, stochastic control, optimal stopping, Markov chain approximation
JEL Classification: C61, G11, G13
Suggested Citation: Suggested Citation