Valuing American Options by Simulation

Hansjörg Furrer

Market-consistent Actuarial Valuation

ETH Zürich, Frühjahrssemester 2008

Valuing American Options

 Course material

• Slides

• Longstaff, F. A. and Schwartz, E. S. (2001). Valuing American

Options by Simulation: A Simple Least-Squares Approach. The
Review of Financial Studies, Vol. 14, No. 1, pp. 113-147.

• The above two documents can be downloaded from

www.math.ethz.ch/~hjfurrer/teaching/

Valuing American Options 1

 American Options
Definition: Contract between two parties giving the buyer the right to, say,
purchase one unit of a security for the amount K at any time on or before
maturity T .

Recall that a European option, in contrast, can only be exercised at a fixed date

General facts:

• An American option can only be exercised once

• The buyer of the option has the choice when to stop

• American options are more valuable than their European counterparts

Valuing American Options 2

 General Facts (cont’d)

• Valuing an American option entails

1. finding the optimal exercise rule
2. computing the expected discounted payoff under this rule

• Exercise decision can only be based on price information up to the present

moment → filtration, stopping times

• The price of an American call option equals the price of the European call
option. Hence, it is optimal to wait until the option expires.

Valuing American Options 3

 Problem Formulation

• Y = {Y (t) : 0 ≤ t ≤ T } with Y (t) representing the payoff from exercise at

time t. Example: Y (t) = (K − S(t))+
Rt
• B = {B(t) : 0 ≤ t ≤ T } with B(t) = exp{ 0 ru du} money market account and
{rt : 0 ≤ t ≤ T } instantaneous short rate process

• U = {U (t) : 0 ≤ t ≤ T } price process

• If the option seller knew in advance which stopping time τ0 the investor will use,
then
 
Y (τ0)
+
U (0) = EQ , Y (t) = K − S(t)
B(τ0)

Valuing American Options 4

 Problem Formulation (cont’d)
• Since τ is not known, the option seller should prepare for the worst possible
case, and charge the maximum value
 
Y (τ )
U (0) = sup EQ ,
τ ∈T B(τ )

where T are the stopping times taking values in [0, T ]

• Often, restriction is made to options that can be exercised only at a fixed set of
dates t1 < t2 < · · · < tm

• Restriction can be part of the option contract (“Bermudan Options”)

• Or the restriction can be regarded as an approximation to a contract allowing

continuous exercise

Valuing American Options 5

 Main result
• Proposition. Suppose there is Q ∼ P and define Z = {Z(t) : 0 ≤ t ≤ T } by
 
Y (τ )
Z(t) = sup EQ Ft B(t) . (1)
τ ∈Tt,T B(τ )

Then Z(t)/B(t) is the smallest Q-supermartingale satisfying Z(t) ≥ Y (t).

Moreover, the supremum in (1) is achieved by an optimal stopping time τ (t)
that has the form 
τ (t) = inf s ≥ t : Z(s) = Y (s) (2)
In other words, τ (t) maximises the right hand side of (1):
   
Y (τ (t)) Y (τ )
EQ Ft = sup EQ Ft .
B(τ (t)) τ ∈Tt,T B(τ )

Valuing American Options 6

 Dynamic Programming Formulation
• Sketch of the proof: idea is to work backwards in time

• Explicit construction of Z(t) by means of dynamic programming:




Y (t) , t=T



 (   )
 V (t + 1)
V (t) := max Y (t), EQ Ft B(t) , t≤T −1 (3)

 B(t + 1)



 | {z }


expected payoff from continuation

• V = {V (t) : 0 ≤ t ≤ T } is called snell envelope. It is the smallest

supermartingale dominating Y and it follows that Z = V .

Valuing American Options 7

 Decision Rules
• Note: dynamic programming rules (3) focus on option values

• It is also convenient to view the pricing problem through stopping rules:

at any exercise time, compare payoff from immediate exercise with the value
of continuation. Exercise if the immediate payoff is higher

• Continuation value: value of holding rather than exercising the option:

 
V (ti+1)
C(ti) = EQ Fti B(ti) (4)
B(ti+1)

• Note: estimating these conditional expectations is the main difficulty in pricing

American options by simulation

Valuing American Options 8

 Regression-Based Methods: The LSM Algorithm

• Idea: Use regression methods to estimate the continuation values from simulated
sample paths

• Each continuation value C(ti) is the regression of the (discounted) option value
V (ti+1) on the current state S(ti)

• In practice:
1. approximate C(ti) by a linear combination of known functions of the current
state S(ti):
∞
X

C(ti) = αij Lj S(ti) ,
j=0
where αij ∈ R and Lj (x) are basis functions (e.g. Laguerre, Legendre, Hermite
polynomials)

Valuing American Options 9

 2. use regression to estimate the coefficients αij in this approximation. The
coefficients αij are estimated from pairs


S(ti, ω), V (ti+1, ω)

consisting of the value of the underlying at time ti and the corresponding

option value at time ti+1

• Remarks:
- the accuracy depends on the choice of basis functions
M
X

- obviously, a finite sum will have to do it: C(ti) = αij Lj S(ti)
j=0
- the coefficients αij are determined by means of least-squares → α̂ij

- The Longstaff-Schwartz LSM-algorithm is a fast and broadly applicable

algorithm (beyond classical American put options)

Valuing American Options 10

 Pricing Algorithm

(i) Simulate n independent paths

S(t1, ωk ), S(t2, ωk ), . . . , S(tm, ωk ) , k = 1, 2, . . . , n

under the risk neutral measure Q

(ii) At terminal nodes, set

V̂ (tm, ωk ) = Y (tm, ωk )

Valuing American Options 11

 Pricing Algorithm (cont’d)

(iii) Apply backward induction: for i = m − 1, . . . , 1

• Given estimated values V̂ (ti+1, ωk ), use regression to calculate α̂i1, . . . , α̂iM

• Set 
Y (ti, ωk ), Y (ti, ωk ) ≥ Ĉ(ti, ωk ),
V̂ (ti, ωk ) =
V̂ (ti+1, ωk ), Y (ti, ωk ) < Ĉ(ti, ωk ),


PM

with Ĉ(ti) = j=0 α̂ij Lj S(ti )

(iv) Set
n
1X
V̂ (0) = V̂ (t1, ωk ) 
n
k=1
Valuing American Options 12
 Numerical Example

• Ω = {ω1, . . . , ω8}, K = 1.1 and S(ti, ωk ) as follows:

t0 = 0 t1 = 1 t2 = 2 t3 = 3
ω1 1 1.09 1.08 1.34
ω2 1 1.16 1.26 1.54
ω3 1 1.22 1.07 1.03
ω4 1 0.93 0.97 0.92
ω5 1 1.11 1.56 1.52
ω6 1 0.76 0.77 0.90
ω7 1 0.92 0.84 1.01
ω8 1 0.88 1.22 1.34

Valuing American Options 13

 Stock Price Evolution







   

Valuing American Options 14