A fast Fourier transform technique for pricing American options under stochastic volatility

Oleksandr Zhylyevskyy

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: This paper develops a non-finite-difference-based method of American option pricing under stochastic volatility by extending the Geske-Johnson compound option scheme. The characteristic function of the underlying state vector is inverted to obtain the vector’s density using a kernel-smoothed fast Fourier transform technique. The method produces option values that are closely in line with the values obtained by finite-difference schemes. It also performs well in an empirical application with traded S&P 100 index options. The method is especially well suited to price a set of options with different strikes on the same underlying asset, which is a task often encountered by practitioners.

Date: 2010-01-01
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