a1 ISCTE Business School, Complexo INDEG/ISCTE, Av. Prof. Aníbal Bettencourt, 1600-189 Lisboa, Portugal. [email protected]
This paper proposes an alternative characterization of the early exercise premium that is valid for any Markovian and diffusion underlying price process as well as for any parameterization of the exercise boundary. This new representation is shown to provide the best pricing alternative available in the literature for medium- and long-term American option contracts, under the constant elasticity of variance model. Moreover, the proposed pricing methodology is also extended easily to the valuation of American options on defaultable equity and possesses appropriate asymptotic properties.
An earlier version of this paper was presented at the 2006 Derivatives Securities and Risk Management Conference (Arlington, VA) and at the 2006 Bachelier Finance Society Fourth World Congress (Tokyo), under the title “A General Characterization of the Early Exercise Premium.” The author thanks Hendrik Bessembinder (the editor) and Ren-Raw Chen (the referee), whose suggestions have significantly improved this article, as well as the helpful programming codes and comments provided by Nico Temme. Of course, all the remaining errors are the author’s responsibility exclusively.