American Option Valuation under Stochastic Interest Rates

Author: Chung S-L.

Source: Review of Derivatives Research, Volume 3, Number 3, 2000 , pp. 283-307(25)

Publisher: Springer

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Abstract:

By applying Ho, Stapleton and Subrahmanyam's (1997, hereafter HSS) generalised Geske–Johnson (1984, hereafter GJ) method, this paper provides analytic solutions for the valuation and hedging of American options in a stochastic interest rate economy. The proposed method simplifies HSS's three-dimensional solution to a one-dimensional solution. The simulations verify that the proposed method is more efficient and accurate than the HSS (1997) method. We illustrate how the price, the delta, and the rho of an American option vary between the stochastic and non-stochastic interest rate models. The magnitude of this effect depends on the moneyness of the option, interest rates, volatilities of the underlying asset price and the bond price, as well as the correlation between them.

Keywords: American option pricing; stochastic interest rates; Richardson extrapolation

Language: English

Document Type: Regular paper

Affiliations: 1: Department of Finance, National Central University, Chung Li, 320, Taiwan

Publication date: 2000-01-01