American Options: An Undergraduate Introduction To Financial Mathematics
American Options: An Undergraduate Introduction To Financial Mathematics
American Options: An Undergraduate Introduction To Financial Mathematics
t
> 1
d: factor by which the stock price may decrease
during a time step.
0 < d = e
t
< 1
p: probability of an increase in stock price during a
time step.
0 < p =
1
2
_
1 +
_
r
2
_
t
_
< 1
J. Robert Buchanan American Options
Illustration
S0
STu S0
p
1p
STd S0
J. Robert Buchanan American Options
Intrinsic Value
Observation: an American put is always worth at least as
much as the payoff generated by immediate exercise.
Denition
The intrinsic value at time t of an American put is the quantity
(K S(t ))
+
.
J. Robert Buchanan American Options
Intrinsic Value
Observation: an American put is always worth at least as
much as the payoff generated by immediate exercise.
Denition
The intrinsic value at time t of an American put is the quantity
(K S(t ))
+
.
The value of an American put is the greater of its intrinsic value
and the present value of its expected intrinsic value at the next
time step.
J. Robert Buchanan American Options
One-Step Illustration (1 of 2)
KS0
Ku S0
Kd S0
_
= max
_
(K S(0))
+
, e
rT
E
_
(K S(T))
+
_
= max
_
(K S(0))
+
, e
rT
E[P
a
(T)]
_
.
J. Robert Buchanan American Options
Two-Step Ilustration (1 of 2)
KS0
Ku S0
Kd S0
Ku
2
S0
Ku d S0
Kd
2
S0
t
1.07484
d = e
t
0.930374
p =
1
2
_
1 +
_
r
2
_
t
_
0.500722.
J. Robert Buchanan American Options
Solution (2 of 3) Stock Prices
150
161.226
139.556
158.291
135.
114.839
J. Robert Buchanan American Options
Solution (3 of 3) Call Prices
1.93942
5.60565
4.00998
11.2255
0
0
8.2911
8.2911
0
0
0
0
J. Robert Buchanan American Options