An approximate moving boundary method for American option pricing

Arun Chockalingam and Kumar Muthuraman

European Journal of Operational Research, 2015, vol. 240, issue 2, 431-438

Abstract: We present a method to solve the free-boundary problem that arises in the pricing of classical American options. Such free-boundary problems arise when one attempts to solve optimal-stopping problems set in continuous time. American option pricing is one of the most popular optimal-stopping problems considered in literature. The method presented in this paper primarily shows how one can leverage on a one factor approximation and the moving boundary approach to construct a solution mechanism. The result is an algorithm that has superior runtimes-accuracy balance to other computational methods that are available to solve the free-boundary problems. Exhaustive comparisons to other pricing methods are provided. We also discuss a variant of the proposed algorithm that allows for the computation of only one option price rather than the entire price function, when the requirement is such.

Keywords: Stochastic control; Optimal stopping; Free boundary PDEs; Approximate boundaries (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (11)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:240:y:2015:i:2:p:431-438

DOI: 10.1016/j.ejor.2014.07.031

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