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Pricing American Options Fitting the Smile

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  • M. A. H. Dempster
  • D. G. Richards

Abstract

This paper is a compendium of results—theoretical and computational—from a series of recent papers developing a new American option valuation technique based on linear programming (LP). Some further computational results are included for completeness. A proof of the basic analytical theorem is given, as is the analysis needed to solve the inverse problem of determining local (one‐factor) volatility from market data. The ideas behind a fast accurate revised simplex method, whose performance is linear in time and space discretizations, are described and the practicalities of fitting the volatility smile are discussed. Numerical results are presented which show the LP valuation technique to be extremely fast—lattice speed with PDE accuracy. American options valued in the paper range from vanilla, through exotic with constant volatility, to exotic options fitting the volatility smile.

Suggested Citation

  • M. A. H. Dempster & D. G. Richards, 2000. "Pricing American Options Fitting the Smile," Mathematical Finance, Wiley Blackwell, vol. 10(2), pages 157-177, April.
    • Handle: RePEc:bla:mathfi:v:10:y:2000:i:2:p:157-177
    DOI: 10.1111/1467-9965.00087
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    Cited by:

    1. S. Dyrting, 2004. "Pricing equity options everywhere," Quantitative Finance, Taylor & Francis Journals, vol. 4(6), pages 663-676.
    2. Matthias Fengler, 2009. "Arbitrage-free smoothing of the implied volatility surface," Quantitative Finance, Taylor & Francis Journals, vol. 9(4), pages 417-428.
    3. Topaloglou, Nikolas & Vladimirou, Hercules & Zenios, Stavros A., 2008. "Pricing options on scenario trees," Journal of Banking & Finance, Elsevier, vol. 32(2), pages 283-298, February.
    4. Fusai, Gianluca & Recchioni, Maria Cristina, 2007. "Analysis of quadrature methods for pricing discrete barrier options," Journal of Economic Dynamics and Control, Elsevier, vol. 31(3), pages 826-860, March.
    5. repec:hum:wpaper:sfb649dp2005-020 is not listed on IDEAS
    6. Fengler, Matthias & Hin, Lin-Yee, 2011. "Semi-nonparametric estimation of the call price surface under strike and time-to-expiry no-arbitrage constraints," Economics Working Paper Series 1136, University of St. Gallen, School of Economics and Political Science, revised May 2013.
    7. repec:hum:wpaper:sfb649dp2005-019 is not listed on IDEAS
    8. Fengler, Matthias R. & Härdle, Wolfgang Karl & Mammen, Enno, 2005. "A dynamic semiparametric factor model for implied volatility string dynamics," SFB 649 Discussion Papers 2005-020, Humboldt University Berlin, Collaborative Research Center 649: Economic Risk.

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