Empirical tests of canonical nonparametric American option-pricing methods

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Abstract

Alcock and Carmichael (2008, The Journal of Futures Markets, 28, 717–748) introduce a nonparametric method for pricing American-style options, that is derived from the canonical valuation developed by Stutzer (1996, The Journal of Finance, 51, 1633–1652). Although the statistical properties of this nonparametric pricing methodology have been studied in a controlled simulation environment, no study has yet examined the empirical validity of this method. We introduce an extension to this method that incorporates information contained in a small number of observed option prices. We explore the applicability of both the original method and our extension using a large sample of OEX American index options traded on the S&P100 index. Although the Alcock and Carmichael method fails to outperform a traditional implied-volatility-based Black–Scholes valuation or a binomial tree approach, our extension generates significantly lower pricing errors and performs comparably well to the implied-volatility Black–Scholes pricing, in particular for out-of-the-money American put options. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 30:509–532, 2010

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