American option pricing by a method of error correction

Research output: Contribution to journalArticleResearchpeer-review

Abstract

© 2016 Institute of Industrial Engineers. The real options approach often assumes that investment projects last indefinitely, which is an unrealistic assumption. When projects live finitely, valuation techniques from American option pricing are required. This article presents a method for pricing American options based on the first-passage approach to the problem. The key is to correct the error associated with the price obtained from a rough first approximation. The procedure leads to a significant reduction in error corresponding to the initial approximation. As a particular case of the method proposed, we derive a closed-form approximation of the option price. The existence of a closed-form approximating formula (that does not involve iterative methods) keeps the computational cost low. In terms of accuracy, the method can be compared to much more sophisticated methods. A tight lower bound (given in closed form) is also provided. The method is fast, accurate, flexible, and easy to implement. A spreadsheet suffices for practical implementation.
Original languageEnglish
Pages (from-to)95-111
JournalEngineering Economist
Volume61
Issue number2
DOIs
Publication statusPublished - 2 Apr 2016

Fingerprint Dive into the research topics of 'American option pricing by a method of error correction'. Together they form a unique fingerprint.

Cite this