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A Forward Monte Carlo Method for American Options Pricing

Authors

  • Daniel Wei-Chung Miao,

    1. Daniel Wei-Chung Miao is an Assistant Professor at Graduate Institute of Finance, National Taiwan University of Science and Technology, Taipei, Taiwan
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  • Yung-Hsin Lee

    Corresponding author
    • Yung-Hsin Lee is a Doctoral Student at Graduate Institute of Finance, National Taiwan University of Science and Technology, Taipei, Taiwan
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  • We are grateful for the helpful comments and suggestions from Bob Webb (Editor) and an anonymous referee.

Correspondence author, Graduate Institute of Finance, National Taiwan University of Science and Technology, No. 43, Sec. 4, Keelung Rd., Taipei 106, Taiwan. Tel: +886-3-327-3100, Fax: +886-2-2730-2614, e-mail: d9618002@mail.ntust.edu.tw

Abstract

This study proposes a forward Monte Carlo method for the pricing of American options. The main advantage of this method is that it does not use backward induction as required by other methods. Instead, the proposed approach relies on a wise determination about whether a simulated stock price has entered the exercise region. The validity of the proposed method is supported by the mathematical proofs for the vanilla cases. With some adaption, it is shown that this forward method can be extended to price other American style options such as chooser and exchange options. This study demonstrates the effectiveness of the proposed approach using a series of numerical examples, revealing significant improvements in numerical efficiency and accuracy in contrast with the standard regression-based method of Longstaff and Schwartz (2001). © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 33:369-395, 2013

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