Rationality Parameter for Exercising American Put

Kamille Sofie Tågholt Gad and Jesper Lund Pedersen
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Kamille Sofie Tågholt Gad: Department of Mathematical Sciences, University of Copenhagen, Universitetsparken 5, 2100 Copenhagen, Denmark
Jesper Lund Pedersen: Department of Mathematical Sciences, University of Copenhagen, Universitetsparken 5, 2100 Copenhagen, Denmark

Risks, 2015, vol. 3, issue 2, 1-9

Abstract: In this paper, irrational exercise behavior of the buyer of an American put is characterized by a single parameter. We model irrational exercise rules as the first jump time of a point processes with stochastic intensity. By the rationality parameter, we parameterize a family of stochastic intensities that depends on the value of the put itself. We present a probabilistic proof that the value of the American put using the irrational exercise rule converges to the arbitrage-free price as the rationality parameter converges to infinity. Another application of this result is the penalty method for approximating the price of an American put.

Keywords: behavioral modeling; irrational exercise rule; partial differential equation; penalty method (search for similar items in EconPapers)
JEL-codes: C G0 G1 G2 G3 K2 M2 M4 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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