An integral representation and computation for the solution of American options (Q1612638)

The objective of this paper is to develop a technique to find the solution for the value of American options. It is known that in the case of an American option, the asset can be exercised any time prior to the expiration date. The information when one should exercise the option is provided by a curve called the optimal exercise curve. Mathematically, this curve is characterized as a free boundary to the model equations. An integral representation for both the solution and the optimal exercise curve for American call options is derived in this paper. This integral representation, in particular, can be employed to give a fast and effective computation of the optimal exrcise curve. The American call option is modeled by Black-Scholes model equation associated with initial/final and boundary conditions on a free boundary. Authors' approach is to first find a closed form solution to the Balck-Scholes equation in terms of the free boundary curve. After solving the resulting integral equation numerically for the curve, the numerical curve is substituted into the closed form solution of the Black-Scholes equation, and thereby a solution for the American option is obtained.