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American-type basket option pricing: a simple two-dimensional partial differential equation

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  • Hamza Hanbali
  • Daniel Linders

Abstract

We consider the pricing of American-type basket derivatives by numerically solving a partial differential equation (PDE). The curse of dimensionality inherent in basket derivative pricing is circumvented by using the theory of comonotonicity. We start with deriving a PDE for the European-type comonotonic basket derivative price, together with a unique self-financing hedging strategy. We show how to use the results for the comonotonic market to approximate American-type basket derivative prices for a basket with correlated stocks. Our methodology generates American basket option prices which are in line with the prices obtained via the standard Least-Square Monte-Carlo approach. Moreover, the numerical tests illustrate the performance of the proposed method in terms of computation time, and highlight some deficiencies of the standard LSM method.

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  • Hamza Hanbali & Daniel Linders, 2019. "American-type basket option pricing: a simple two-dimensional partial differential equation," Quantitative Finance, Taylor & Francis Journals, vol. 19(10), pages 1689-1704, October.
    • Handle: RePEc:taf:quantf:v:19:y:2019:i:10:p:1689-1704
    DOI: 10.1080/14697688.2019.1588987
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    Cited by:

    1. Calypso Herrera & Florian Krach & Pierre Ruyssen & Josef Teichmann, 2021. "Optimal Stopping via Randomized Neural Networks," Papers 2104.13669, arXiv.org, revised Dec 2023.
    2. Karel J. in’t Hout & Jacob Snoeijer, 2021. "Numerical Valuation of American Basket Options via Partial Differential Complementarity Problems," Mathematics, MDPI, vol. 9(13), pages 1-17, June.
    3. Magnus Carlehed, 2023. "A Model for Risk Adjustment (IFRS 17) for Surrender Risk in Life Insurance," Risks, MDPI, vol. 11(3), pages 1-22, March.
    4. Karel in 't Hout & Jacob Snoeijer, 2021. "Numerical valuation of American basket options via partial differential complementarity problems," Papers 2106.01200, arXiv.org.

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