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Pricing and hedging American options in incomplete markets

Pricing and hedging American options in incomplete markets Purpose – This paper sets out to consider the problem that the initial value of the American option is less than its fair price; this implies that the replication portfolio does not exist in the market. Design/methodology/approach – The paper develops an optimization model whose solution provides an optimal strategy for the writer to minimize the expected loss for this problem. Findings – The numerical results reveal that loaning money to construct a replication portfolio may not be an optimal strategy for the writer. Practical implications – The solution of the minimum expected loss model provides an optimal strategy to construct a lower expected loss portfolio. Originality/value – The numerical results reveal that loaning money to construct a replication portfolio may not be an optimal strategy for the writer. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Modelling in Management Emerald Publishing

Pricing and hedging American options in incomplete markets

Hsuan‐Ku Liu; Ming Long Liu
Journal of Modelling in Management , Volume 4 (1): 11 – Mar 13, 2009
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Publisher
Emerald Publishing
Copyright
Copyright © 2009 Emerald Group Publishing Limited. All rights reserved.
ISSN
1746-5664
DOI
10.1108/17465660910943766
Publisher site
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Abstract

Purpose – This paper sets out to consider the problem that the initial value of the American option is less than its fair price; this implies that the replication portfolio does not exist in the market. Design/methodology/approach – The paper develops an optimization model whose solution provides an optimal strategy for the writer to minimize the expected loss for this problem. Findings – The numerical results reveal that loaning money to construct a replication portfolio may not be an optimal strategy for the writer. Practical implications – The solution of the minimum expected loss model provides an optimal strategy to construct a lower expected loss portfolio. Originality/value – The numerical results reveal that loaning money to construct a replication portfolio may not be an optimal strategy for the writer.

Journal

Journal of Modelling in Management – Emerald Publishing

Published: Mar 13, 2009

Keywords: Pricing; Options markets; Hedging; United States of America

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