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Pricing American options by simulation using a stochastic mesh with optimized weights. (English) Zbl 1013.91054

Uryasev, Stanislav P. (ed.), Probabilistic constrained optimization. Methodology and applications. Dordrecht: Kluwer Academic Publishers. Nonconvex Optim. Appl. 49, 26-44 (2000).
Summary: This paper develops a simulation method for pricing path-dependent American options, and American options on a large number of underlying assets, such as basket options. Standard numerical procedures (lattice methods and finite difference methods) are generally inapplicable to such high-dimensional problems, and this has motivated research into simulation-based methods. The optimal stopping problem embedded in the pricing of American options makes this a nonstandard problem for simlation. This paper extends the stochastic mesh introduced by M. Broadie and P. Glasserman, “A stochastic mesh method for pricing high-dimensional American options”, working paper, Columbia University (1997). In its original form, the stochastic mesh method required knowledge of the transition density of the underlying process of asset prices and other state variables. This paper extends the method to settings in which the transition density is either unknown or fails to exist. We avoid the need for a transition density by choosing mesh weights through a constrained optimization problem. If the weights are constrained to correctly price sufficiently many simple instruments, they can be expected to work well in pricing a more complex American option. We investigate two criteria for use in the optimization – maximum entropy and least squares. The methods are illustrated through numerical examples.
For the entire collection see [Zbl 0959.00019].

MSC:

91B28 Finance etc. (MSC2000)
91B82 Statistical methods; economic indices and measures
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