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A quasi-analytical interpolation method for pricing American options under general multi-dimensional diffusion processes

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  • Minqiang Li
Abstract
We present a quasi-analytical method for pricing multi-dimensional American options based on interpolating two arbitrage bounds, along the lines of Johnson (1983). Our method allows for the close examination of the interpolation parameter on a rigorous theoretical footing instead of empirical regression. The method can be adapted to general diffusion processes as long as quick and accurate pricing methods exist for the corresponding European and perpetual American options. The American option price is shown to be approximately equal to an interpolation of two European option prices with the interpolation weight proportional to a perpetual American option. In the Black-Scholes model, our method achieves the same e±ciency as Barone-Adesi and Whaley's (1987) quadratic approximation with our method being generally more accurate for out-of-the-money and long-maturity options. When applied to Heston's stochastic volatility model, our method is shown to be extremely e±cient and fairly accurate.
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  • Minqiang Li, 2010. "A quasi-analytical interpolation method for pricing American options under general multi-dimensional diffusion processes," Review of Derivatives Research, Springer, vol. 13(2), pages 177-217, July.
    • Handle: RePEc:kap:revdev:v:13:y:2010:i:2:p:177-217
    DOI: 10.1007/s11147-009-9047-0
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    2. Dasheng Ji & B. Brorsen, 2011. "A recombining lattice option pricing model that relaxes the assumption of lognormality," Review of Derivatives Research, Springer, vol. 14(3), pages 349-367, October.

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    More about this item

    Keywords

    American option; Interpolation method; Quasi-analytical approximation; Critical boundary; Heston’s Stochastic volatility model; C02; C63; G13;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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