An Approximate Moving Boundary Method for American Options

Abstract

We present a method to solve the free-boundary problem that arises in the pricing of classical American options. The method presented herein leverages on a one factor approximation and the moving boundary approach to yield an algorithm which has superior run times and accuracy as compared other computational methods that can solve the free-boundary problem. Exhaustive comparisons to other pricing methods are provided. We also discuss a variant of the proposed algorithm that allows the computation of only an option price rather than the entire price function, when the requirement is such.

Keywords: American option pricing, free boundary, Moving Boundary method, approximate boundaries

JEL Classification: G13, C63