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Non-Traded Asset Valuation with Portfolio Constraints: A Binomial Approach

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  • Jérôme Detemple
  • Suresh Sundaresan

Abstract

We provide a simple binomial framework to value American-style derivatives subject to trading restrictions. The optimal investment of liquid wealth is solved simultaneously with the early exercise decision of the non-traded derivative. No-short-sales constraints on the underlying asset manifest themselves in the form of an implicit dividend yield in the risk neutralized process for the underlying asset. One consequence is that American call options may be optimally exercised prior to maturity even when the underlying asset pays no dividends. Applications to executive compensation options are presented. We also analyze non-traded payoffs based on a price that is imperfectly correlated with the price of a traded asset. Cet article développe un modèle binomial d'évaluation des titres dérivés américains en présence de contraintes d'investissement. Les politiques optimales d'investissement et d'exercice du titre dérivé non-marchandé sont résolues de manière simultanée . La contrainte d'absence de ventes à découvert se manifeste sous forme d'un dividende implicite portant sur le processus neutre au risque de l'actif sous-jacent. Une des conséquences est l'optimalité possible de l'exercice avant l'expiration du contrat même lorsque l'actif sous-jacent ne paye pas de dividendes. Une application à l'évaluation des options de compensation des cadres d'entreprises est présentée. Nous étudions également l'évaluation de titres basés sur un prix qui est imparfaitement corrélé avec le prix d'un actif transigé.

Suggested Citation

  • Jérôme Detemple & Suresh Sundaresan, 1999. "Non-Traded Asset Valuation with Portfolio Constraints: A Binomial Approach," CIRANO Working Papers 99s-08, CIRANO.
    • Handle: RePEc:cir:cirwor:99s-08
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    References listed on IDEAS

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