An Analytic Approximation of the Implied Risk-Neutral Density of American Multi-Asset Options
The price of a European option can be computed as the expected value of the payoff function under the risk-neutral measure. For American options and path-dependent options in general, this principle can not be applied. In this paper, we derive a model-free analytical formula for the implied risk-neutral density under which the expected value will be the price of the equivalent payoff with the American exercise condition. The risk-neutral density is semi-parametric as it is the result of applying the multivariate generalised Edgeworth expansion (MGEE), where the moments of the American density are obtained by a reverse engineering application of the Longstaff and Schwartz (2001) least-squares method (LSM). The theory of multivariate truncated moments is employed for approximating the option price, with important consequences for the hedging of variance, skewness, and kurtosis swaps.
|Published on||26th August 2014|
|Authors||Juan C. Arismendi, ICMA Centre and Universidade de Brasília (UnB) and Marcel Prokopczuk, Zeppelin University and ICMA Centre|