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Confined exponential approximations for the valuation of American options

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  • Jongwoo Lee
  • Dean Paxson

Abstract

We provide an alternative analytic approximation for the value of an American option using a confined exponential distribution with tight upper bounds. This is an extension of the Geske and Johnson compound option approach and the Ho et al. exponential extrapolation method. Use of a perpetual American put value, and then a European put with high input volatility is suggested in order to provide a tighter upper bound for an American put price than simply the exercise price. Numerical results show that the new method not only overcomes the deficiencies in existing two-point extrapolation methods for long-term options but also further improves pricing accuracy for short-term options, which may substitute adequately for numerical solutions. As an extension, an analytic approximation is presented for a two-factor American call option.

Suggested Citation

  • Jongwoo Lee & Dean Paxson, 2003. "Confined exponential approximations for the valuation of American options," The European Journal of Finance, Taylor & Francis Journals, vol. 9(5), pages 449-474.
    • Handle: RePEc:taf:eurjfi:v:9:y:2003:i:5:p:449-474
    DOI: 10.1080/1351847032000082796
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    References listed on IDEAS

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    3. Cassimon, D. & Engelen, P.J. & Thomassen, L. & Van Wouwe, M., 2007. "Closed-form valuation of American call options on stocks paying multiple dividends," Finance Research Letters, Elsevier, vol. 4(1), pages 33-48, March.
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    5. Dean Paxson, 2007. "Sequential American Exchange Property Options," The Journal of Real Estate Finance and Economics, Springer, vol. 34(1), pages 135-157, January.

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