Improved lower and upper bound algorithms for pricing American options by simulation

Mark Broadie and Menghui Cao

Quantitative Finance, 2008, vol. 8, issue 8, 845-861

Abstract: This paper introduces new variance reduction techniques and computational improvements to Monte Carlo methods for pricing American-style options. For simulation algorithms that compute lower bounds of American option values, we apply martingale control variates and introduce the local policy enhancement, which adopts a local simulation to improve the exercise policy. For duality-based upper bound methods, specifically the primal-dual simulation algorithm, we have developed two improvements. One is sub-optimality checking, which saves unnecessary computation when it is sub-optimal to exercise the option along the sample path; the second is boundary distance grouping, which reduces computational time by skipping computation on selected sample paths based on the distance to the exercise boundary. Numerical results are given for single asset Bermudan options, moving window Asian options and Bermudan max options. In some examples the computational time is reduced by a factor of several hundred, while the confidence interval of the true option value is considerably tighter than before the improvements.

Keywords: Financial derivatives; Financial economics; Financial engineering; Implementation of pricing derivatives; Computational finance (search for similar items in EconPapers)
Date: 2008
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Citations: View citations in EconPapers (34)

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DOI: 10.1080/14697680701763086

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