Confined exponential approximations for the valuation of American options

Jongwoo Lee and Dean Paxson

The European Journal of Finance, 2003, vol. 9, issue 5, 449-474

Abstract: We provide an alternative analytic approximation for the value of an American option using a confined exponential distribution with tight upper bounds. This is an extension of the Geske and Johnson compound option approach and the Ho et al. exponential extrapolation method. Use of a perpetual American put value, and then a European put with high input volatility is suggested in order to provide a tighter upper bound for an American put price than simply the exercise price. Numerical results show that the new method not only overcomes the deficiencies in existing two-point extrapolation methods for long-term options but also further improves pricing accuracy for short-term options, which may substitute adequately for numerical solutions. As an extension, an analytic approximation is presented for a two-factor American call option.

Keywords: confined exponential distribution; analytical approximations; tight upper bounds; two-factor American option (search for similar items in EconPapers)
Date: 2003
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Citations: View citations in EconPapers (5)

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DOI: 10.1080/1351847032000082796

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