Regression-Based Monte Carlo For Pricing High-Dimensional American-Style Options

University essay from Umeå universitet/Institutionen för fysik


Pricing different financial derivatives is an essential part of the financial industry. For some derivatives there exists a closed form solution, however the pricing of high-dimensional American-style derivatives is still today a challenging problem. This project focuses on the derivative called option and especially pricing of American-style basket options, i.e. options with both an early exercise feature and multiple underlying assets. In high-dimensional problems, which is definitely the case for American-style options, Monte Carlo methods is advantageous. Therefore, in this thesis, regression-based Monte Carlo has been used to determine early exercise strategies for the option. The well known Least Squares Monte Carlo (LSM) algorithm of Longstaff and Schwartz (2001) has been implemented and compared to Robust Regression Monte Carlo (RRM) by C.Jonen (2011). The difference between these methods is that robust regression is used instead of least square regression to calculate continuation values of American style options. Since robust regression is more stable against outliers the result using this approach is claimed by C.Jonen to give better estimations of the option price.

It was hard to compare the techniques without the duality approach of Andersen and Broadie (2004) therefore this method was added. The numerical tests then indicate that the exercise strategy determined using RRM produces a higher lower bound and a tighter upper bound compared to LSM. The difference between upper and lower bound could be up to 4 times smaller using RRM.

Importance sampling and Quasi Monte Carlo have also been used to reduce the variance in the estimation of the option price and to speed up the convergence rate.

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