Pricing the exotic: Path-dependent American options with stochastic barriers

Abstract

We develop a novel pricing strategy that approximates the value of an American option with exotic features through a portfolio of European options with different maturities. Among our findings, we show that (i) our model is numerically robust in pricing plain vanilla American options; (ii) the model matches observed bids and premiums of multidimensional options that integrate Ratchet, Asian, and Barrier characteristics; and (iii) our closed-form approximation allows for an analytical solution of the option’s greeks, which characterize the sensitivity to various risk factors. Finally, compared to the traditional Monte Carlo simulations method, we highlight that our estimation has a more accurate prediction and requires less than 1% of the computational time.

Publication
Latin American Journal of Central Banking, 2(1)
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