Discrete-time pricing and optimal exercise of American perpetual warrants in the geometric random walk model
Vanderbei, R. J.
Pinar, M. C.
Bozkaya, E. B.
Applied Mathematics and Optimization
Vanderbei, R. J., Pınar, M. Ç., & Bozkaya, E. B. (2013). Discrete-Time Pricing and Optimal Exercise of American Perpetual Warrants in the Geometric Random Walk Model. Applied Mathematics & Optimization, 67(1), 97-122.
Please cite this item using this persistent URLhttp://hdl.handle.net/11693/11924
An American option (or, warrant) is the right, but not the obligation, to purchase or sell an underlying equity at any time up to a predetermined expiration date for a predetermined amount. A perpetual American option differs from a plain American option in that it does not expire. In this study, we solve the optimal stopping problem of a perpetual American option (both call and put) in discrete time using linear programming duality. Under the assumption that the underlying stock price follows a discrete time and discrete state Markov process, namely a geometric random walk, we formulate the pricing problem as an infinite dimensional linear programming (LP) problem using the excessive-majorant property of the value function. This formulation allows us to solve complementary slackness conditions in closedform, revealing an optimal stopping strategy which highlights the set of stock-prices where the option should be exercised. The analysis for the call option reveals that such a critical value exists only in some cases, depending on a combination of statetransition probabilities and the economic discount factor (i.e., the prevailing interest rate) whereas it ceases to be an issue for the put.