Extended Nonparametric American Option Pricing

35 Pages Posted: 29 Feb 2008

See all articles by Jamie Alcock

Jamie Alcock

University of Oxford

Diana Auerswald

Goethe University Frankfurt - Department of Finance

Date Written: February 29, 2008

Abstract

A nonparametric method of pricing American options was recently developed that requires only historical underlying price data (Alcock and Carmichael, 2008). We derive an extension to this method to include conditioning information from a small number of observed option prices. This additional information improves the overall accuracy of the method and enables pricing of illiquid options in an incomplete market. We explore the statistical properties of both the original method and our extension using a series of simulation studies. The original method slightly outperforms Black-Scholes estimators and numerical estimators (Crank-Nicholson) that use historical volatility. In contrast, the extended method presented here produces significant reductions in mean pricing errors. These reductions are most dramatic for out-of-the-money options; a result that is consistent with empirical results for related entropic methodologies for pricing European options.

Keywords: Nonparametric Option Pricing, American Options, Canonical Pricing

JEL Classification: G12, G13, C14, C63

Suggested Citation

Alcock, Jamie and Auerswald, Diana, Extended Nonparametric American Option Pricing (February 29, 2008). Available at SSRN: https://ssrn.com/abstract=1097526 or http://dx.doi.org/10.2139/ssrn.1097526

Jamie Alcock (Contact Author)

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

Diana Auerswald

Goethe University Frankfurt - Department of Finance ( email )

Mertonstr. 17
Frankfurt, 60054
Germany

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