American options with discontinuous two-level caps

DOI10.1137/17M1110791MaRDI QIDQ4635248zbMATH OpenOpenAlexFDO

Authors Yerkin Kitapbayev, Jérôme Detemple

Publication date 16 April 2018

Published in SIAM Journal on Financial Mathematics (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1707.06138

zbMATH Keywords

integral equationfree-boundary problemgeometric Brownian motionlocal timeoptimal stoppingAmerican capped option

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) Diffusion processes (60J60) Free boundary problems for PDEs (35R35) Other nonlinear integral equations (45G10) Stopping times; optimal stopping problems; gambling theory (60G40)

Abstract: This paper examines the valuation of American capped call options with two-level caps. The structure of the immediate exercise region is significantly more complex than in the classical case with constant cap. When the cap grows over time, making extensive use of probabilistic arguments and local time, we show that the exercise region can be the union of two disconnected set. Alternatively, it can consist of two sets connected by a line. The problem then reduces to the characterization of the upper boundary of the first set, which is shown to satisfy a recursive integral equation. When the cap decreases over time, the boundary of the exercise region has piecewise constant segments alternating with non-increasing segments. General representation formulas for the option price, involving the exercise boundaries and the local time of the underlying price process, are derived. An efficient algorithm is developed and numerical results are provided.

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Cites work

• scientific article; zbMATH DE number 5016447 (Why is no real title available?)
• scientific article; zbMATH DE number 1284287 (Why is no real title available?)
• A change-of-variable formula with local time on curves
• American-style derivatives. Valuation and computation.
• Finite horizon optimal stopping of time-discontinuous functionals with applications to impulse control with delay
• On the pricing of American options

Cited in

(3)

• Stopping spikes, continuation bays and other features of optimal stopping with finite-time horizon
• Double continuation regions for American options under Poisson exercise opportunities
• American step options

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