New Model Accounts for ‘Floating’ Exercise Boundaries in American Options Amid Negative Rates
A new pricing model extends existing approaches to account for the complexities introduced by negative interest rates and convenience yields, potentially impacting the valuation of American options across various asset classes. The model, detailed in a recent report, addresses how exercise boundaries can become dynamically unstable – exhibiting a “floating” structure – under these unconventional market conditions.
Andrey Itkin and Yerkin Kitapbayev examine a semi-analytical approach for pricing American options in time-inhomogeneous models, specifically those characterized by negative interest rates (common in equities and foreign exchange markets) or negative convenience yields (prevalent in commodities and cryptocurrencies). This research is particularly relevant as central banks globally have experimented with negative interest rate policies in recent years, and the commodities market increasingly includes digital assets with unique yield characteristics.
The core challenge lies in how traditional option pricing models struggle when interest rates fall below zero or convenience yields turn negative. Under these circumstances, the optimal time to exercise an American option – which can be exercised at any time before expiration – becomes less clear. The researchers found that exercise boundaries, which define the point at which it becomes profitable to exercise an option, may no longer be static. Instead, they can “float,” appearing and disappearing dynamically as market conditions shift.
“Under such conditions, exercise boundaries may exhibit a ‘floating’ structure, dynamically appearing,” the report states, highlighting the need for more sophisticated modeling techniques.
The semi-analytical approach developed by Itkin and Kitapbayev offers a potential solution. It provides a framework for calculating option prices and exercise boundaries in these complex scenarios, offering a more accurate valuation than traditional methods. However, access to the full report requires a paid subscription to Risk.net. Users without a subscription are unable to print or copy the content and are directed to contact [email protected] or visit http://subscriptions.risk.net/subscribe for subscription options.
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