Valuation of American options in the presence of event risk (Q1776028)

The author computes the optimal exercise time and the corresponding option price for ``risky'' American options in the presence of external/non-hedgeable event risk. The market model consists of a risk-free security given by the money market account and a risky security. The market model is originally complete, but becomes incomplete when adding the non-hedgeable event risk. However, the event risk is introduced in a way such that the market remains free of arbitrage opportunities. When the event occurs, the American option is terminated and a rebate is paid instead of the promised pay-off profile. Consequently, the presence of event risk influences the exercise strategy of the option holder. The probabilistic structure in terms of equivalent martingale measures is briefly analyzed and the results are given: for any arbitrarily chosen equivalent martingale measure, the optimal stopping problem of the American option is solved and no-arbitrage bounds for American option values in the presence of event risk are derived, including the corresponding super- and sub-hedging strategies. In particular, the lower price bound is established by combining results on game options with results on event/default risk.