Hermite Polynomial-based Valuation of American Options with General Jump-Diffusion Processes

Li Chen and Guang Zhang

Papers from arXiv.org

Abstract: We present a new approximation scheme for the price and exercise policy of American options. The scheme is based on Hermite polynomial expansions of the transition density of the underlying asset dynamics and the early exercise premium representation of the American option price. The advantages of the proposed approach are threefold. First, our approach does not require the transition density and characteristic functions of the underlying asset dynamics to be attainable in closed form. Second, our approach is fast and accurate, while the prices and exercise policy can be jointly produced. Third, our approach has a wide range of applications. We show that the proposed approximations of the price and optimal exercise boundary converge to the true ones. We also provide a numerical method based on a step function to implement our proposed approach. Applications to nonlinear mean-reverting models, double mean-reverting models, Merton's and Kou's jump-diffusion models are presented and discussed.

Date: 2021-04
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