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A Pricing Model for American Options with Stochastic Interest Rates

Author

Listed:
  • Bert Menkveld

    (VU University Amsterdam)

  • Ton Vorst

    (VU University Amsterdam)

Abstract

In this paper we introduce a new methodology to price American put options under stochastic interestrates. The method is a combination of an analytic approach and a binomial tree approach. We constructa binomial tree for the forward risk adjusted tree and calculate analytically the expected early exercisevalue in each point. For American puts with stochastic interest rates the correlation between the stockprice process has different influences on the European option values and the early exercise premiums.This results in a nonmonotonic relation between this correlation and the American put option value.Furthermore, there is evidence that the early exercise premium due to stochastic interest rates is muchlarger than established before by other researchers.

Suggested Citation

  • Bert Menkveld & Ton Vorst, 1998. "A Pricing Model for American Options with Stochastic Interest Rates," Tinbergen Institute Discussion Papers 98-028/2, Tinbergen Institute.
    • Handle: RePEc:tin:wpaper:19980028
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    References listed on IDEAS

    as
    1. Ho, T S & Stapleton, Richard C & Subrahmanyam, Marti G, 1997. "The Valuation of American Options with Stochastic Interest Rates: A Generalization of the Geske-Johnson Technique," Journal of Finance, American Finance Association, vol. 52(2), pages 827-840, June.
    2. Amin, Kaushik I & Bodurtha, James N, Jr, 1995. "Discrete-Time Valuation of American Options with Stochastic Interest Rates," The Review of Financial Studies, Society for Financial Studies, vol. 8(1), pages 193-234.
    3. Geske, Robert & Johnson, Herb E, 1984. "The American Put Option Valued Analytically," Journal of Finance, American Finance Association, vol. 39(5), pages 1511-1524, December.
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    Cited by:

    1. Huang, Haishi, 2010. "Convertible Bonds: Risks and Optimal Strategies," Bonn Econ Discussion Papers 07/2010, University of Bonn, Bonn Graduate School of Economics (BGSE).

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