Optimal exercise of American options under time-dependent Ornstein-Uhlenbeck processes
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Abstract: We study the barrier that gives the optimal time to exercise an American option written on a time-dependent Ornstein-Uhlenbeck process, a diffusion often adopted by practitioners to model commodity prices and interest rates. By framing the optimal exercise of the American option as a problem of optimal stopping and relying on probabilistic arguments, we provide a non-linear Volterra-type integral equation characterizing the exercise boundary, develop a novel comparison argument to derive upper and lower bounds for such a boundary, and prove its differentiability and Lipschitz continuity in any closed interval that excludes the expiration date. We implement a Picard iteration algorithm to solve the Volterra integral equation and show illustrative examples that shed light on the boundary's dependence on the process's drift and volatility.
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