A dynamic look-ahead Monte Carlo algorithm for pricing Bermudan options

DOI10.1214/105051607000000249zbMATH Open1136.91010arXiv0710.3640OpenAlexW2019703483MaRDI QIDQ2467599FDOQ2467599

Authors: Daniel Egloff, Michael Kohler, Nebojsa Todorovic 

Publication date: 28 January 2008

Published in: The Annals of Applied Probability (Search for Journal in Brave)

Abstract: Under the assumption of no-arbitrage, the pricing of American and Bermudan options can be casted into optimal stopping problems. We propose a new adaptive simulation based algorithm for the numerical solution of optimal stopping problems in discrete time. Our approach is to recursively compute the so-called continuation values. They are defined as regression functions of the cash flow, which would occur over a series of subsequent time periods, if the approximated optimal exercise strategy is applied. We use nonparametric least squares regression estimates to approximate the continuation values from a set of sample paths which we simulate from the underlying stochastic process. The parameters of the regression estimates and the regression problems are chosen in a data-dependent manner. We present results concerning the consistency and rate of convergence of the new algorithm. Finally, we illustrate its performance by pricing high-dimensional Bermudan basket options with strangle-spread payoff based on the average of the underlying assets.

Full work available at URL: https://arxiv.org/abs/0710.3640

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Mathematics Subject Classification ID

Nonparametric estimation (62G05) Monte Carlo methods (65C05) Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60) Stopping times; optimal stopping problems; gambling theory (60G40) Optimal stochastic control (93E20) Least squares and related methods for stochastic control systems (93E24)

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