A generalized Brennan–Rubinstein approach for valuing options with stochastic interest rates

Chuang-Chang Chang, Min-Hung Tsay and Jun-Biao Lin

The Quarterly Review of Economics and Finance, 2018, vol. 67, issue C, 92-99

Abstract: We construct a discrete-time option valuation model capable of taking into consideration multiple exercises and stochastic interests rates under a generalized Brennan–Rubinstein framework, and further apply the Geske and Johnson (1984) method for the valuation of American options. For implementation, we use only the once- and twice-exercisable option values to approximate American option values. Our numerical results show that the effects of stochastic interest rates are very large, particularly for out-of-the-money American put options with a high-risk underlying asset price. For options with a high-risk return on asset as the underlying assets, the effects of stochastic interest rates are negligible, even for options with long-term maturity. Finally, the sign of correlation between asset prices and bond prices plays an important role in determining whether the values of American put options under stochastic interest rates are larger or smaller than those under constant interest rates.

Keywords: Generalized Brennan–Rubinstein framework; Geske and Johnson method; American put options (search for similar items in EconPapers)
Date: 2018
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Persistent link: https://EconPapers.repec.org/RePEc:eee:quaeco:v:67:y:2018:i:c:p:92-99

DOI: 10.1016/j.qref.2017.05.003

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