Entropy-regularized penalization schemes for American options and reflected BSDEs with singular generators

Daniel Chee, Noufel Frikha and Libo Li

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Abstract: This paper extends our previous work in Chee et al. [9] to continuous-time optimal stopping problems, with a particular focus on American options within an exploratory framework. We pursue two main objectives. First, motivated by reinforcement learning applications, we introduce an entropy-regularized penalization scheme for continuous-time optimal stopping problems. The scheme is inspired by classical penalization techniques for reflected backward stochastic differential equations (RBSDEs) and provides a smooth approximation of the degenerate stopping rule inherent to the American option problem. This regularization promotes exploration, enables the use of gradient-based optimization methods, and leads naturally to policy improvement algorithms. We establish well-posedness and convergence properties of the scheme, and illustrate its numerical feasibility through low-dimensional experiments based on policy iteration and least-squares Monte Carlo methods. Second, from a theoretical perspective, we study the asymptotic limit of the entropy-regularized penalization as the penalization parameter tends to infinity. We show that the limiting value process solves a reflected BSDE with a logarithmically singular driver, and we prove existence and uniqueness of solutions to this new class of RBSDEs via a monotone limit argument. To the best of our knowledge, such equations have not previously been investigated in the literature

Date: 2026-02
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