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An Improved Method for Pricing and Hedging Long Dated American Options

Fabozzi, Frank J., Paletta, Tommaso, Stanescu, Silvia, Tunaru, Radu (2016) An Improved Method for Pricing and Hedging Long Dated American Options. European Journal of Operational Research (ABS 4), 254 (2). pp. 656-666. ISSN 0377-2217. (doi:10.1016/j.ejor.2016.04.002) (KAR id:55269)

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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. We introduce a new methodology to increase the accuracy of almost any existing quasi-analytic approach in pricing long-maturity American options. The new methodology, called the "extension-method", 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. Our method retains the quasi-analytic nature of the methods it improves. Generic quasi-analytic formulae for the price of an American put as well as for its hedging parameter are derived. Our scenarios-based numerical study indicates that our method considerably improves both the pricing and the hedging performance of a number of established approaches for a wide range of maturities. The superiority of this approach is illustrated with real financial data by considering S&P100 LEAPS options traded from January 2008 to May 2015.

Item Type: Article
DOI/Identification number: 10.1016/j.ejor.2016.04.002
Additional information: There is also an Online Appendix available with this paper that contains supplementary material.
Uncontrolled keywords: American options, Optimal exercise price, Quasi-analytic method, Delta-hedging, LEAPS
Subjects: H Social Sciences > HA Statistics > HA33 Management Science
H Social Sciences > HG Finance
Divisions: Faculties > Sciences > School of Mathematics Statistics and Actuarial Science
Faculties > Social Sciences > Kent Business School
Depositing User: Radu Tunaru
Date Deposited: 05 May 2016 10:10 UTC
Last Modified: 30 Jan 2020 08:58 UTC
Resource URI: (The current URI for this page, for reference purposes)
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