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Pricing American Options on Foreign Assets in a Stochastic Interest Rate Economy

Published online by Cambridge University Press:  06 April 2009

San-Lin Chung
San-Lin Chung
Affiliation:
chungs@mgt.ncu.edu.tw, Department of Finance, National Central University, Chung-Li, 320, Taiwan, R.O.C.
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Abstract

This paper values American options on foreign assets in a stochastic interest rate economy using a two-point Geske and Johnson (1984) technique. The method requires the valuation of just two options: a European option and a twice-exercisable option. I first derive the risk-neutral distributions of asset prices under two forward risk-adjusted measures. Closed form solutions for European options on foreign assets are then obtained by applying these risk-neutral distributions. This article also provides analytic solutions for pricing twice exercisable options that are at most two-dimensional even though the valuation problem involves four risk factors at two exercise dates. I report the results of numerical evaluations of American option values using my method and show how they vary with the interest rate parameters. I also verify the accuracy of the proposed method by comparing with the benchmark values obtained from the least-square method of Longstaff and Schwartz (2001).

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 37 , Issue 4 , December 2002 , pp. 667 - 692
Copyright
Copyright © School of Business Administration, University of Washington 2002

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