A dynamic look-ahead Monte Carlo algorithm for pricing Bermudan options
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Publication:2467599
Stopping times; optimal stopping problems; gambling theory (60G40) Nonparametric estimation (62G05) Monte Carlo methods (65C05) Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60) Optimal stochastic control (93E20) Least squares and related methods for stochastic control systems (93E24)
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.
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