| Article ID | Journal | Published Year | Pages | File Type |
|---|---|---|---|---|
| 479753 | European Journal of Operational Research | 2015 | 8 Pages |
•We tackle the free boundary problem of pricing American options.•We use a one factor approximation of the optimal exercise boundary.•The approximation allows us to compute option prices quickly.•Using an approximation results in an insignificant loss in accuracy.•The approximation could be used to compute the price of a single option using the PDE.
We present a method to solve the free-boundary problem that arises in the pricing of classical American options. Such free-boundary problems arise when one attempts to solve optimal-stopping problems set in continuous time. American option pricing is one of the most popular optimal-stopping problems considered in literature. The method presented in this paper primarily shows how one can leverage on a one factor approximation and the moving boundary approach to construct a solution mechanism. The result is an algorithm that has superior runtimes-accuracy balance to other computational methods that are available to solve the free-boundary problems. Exhaustive comparisons to other pricing methods are provided. We also discuss a variant of the proposed algorithm that allows for the computation of only one option price rather than the entire price function, when the requirement is such.
