24 Pages Posted: 22 Jun 2006 Last revised: 23 Nov 2008
Date Written: May 15, 2007
This paper describes a method to solve the free-boundary problem that arises in the pricing of American options. Most numerical methods for American option pricing exploit the representation of the option price as the expected pay-off under the risk-neutral measure and calculate the price for a given time to expiration and stock price. They do not solve the related free-boundary problem explicitly. The advantage of solving the free-boundary problem is that it provides the entire price function as well as the optimal exercise boundary explicitly. Our approach, which we term the Moving Boundary Approach, is based on using a boundary guess and the value associated with the guess to construct an improved boundary. It is also shown that on iteration, the sequence of boundaries converge monotonically to the optimal exercise boundary. Examples illustrating the convergence behavior as well as discussions providing insight into the method are also presented. Finally, we compare run times and speeds with other methods that solve the free-boundary problem and compute the optimal boundaries explicitly, like the front-fixing method, penalty method, method based on the integral representations and the method by Brennan and Schwartz (1977).
Keywords: American Option Pricing, stochastic control, Hamilton-Jacobi-Bellman equation, free boundary
JEL Classification: G12, C63
Suggested Citation: Suggested Citation
Muthuraman, Kumar, A Moving Boundary Approach to American Option Pricing (May 15, 2007). McCombs Research Paper Series No. IROM-06-08. Available at SSRN: https://ssrn.com/abstract=910882 or http://dx.doi.org/10.2139/ssrn.910882