Traded American options are Bermudan

Abstract

Purpose

The purpose of this paper is to study the importance of business time, and market opening/closing times and days, for American option pricing.

Design/methodology/approach

A Bermudan pricing approach is employed whereby the option can be exercised only during the times and days the market is open. The authors apply the approach to the S&P 100 options market.

Findings

It was found that the potential biases that can arise from ignoring the non‐continuous operation of the market are not negligible.

Research limitations/implications

For expositional purposes, the authors assume that the price of the underlying follows a Geometric Brownian motion. This assumption could be relaxed by future research and more complex price dynamics models could be considered.

Practical implications

The findings in this paper could be used in correcting observed option prices, prior to investigating the rationality of early exercise decisions, or in measuring the size of early exercise premia.

Originality/value

This is the first study to examine the effects of business time, and market opening/closing times and days, to American option prices.

Citation

Kourtis, A. and Markellos, R.N. (2011), "Traded American options are Bermudan", Managerial Finance, Vol. 37 No. 11, pp. 978-984. https://doi.org/10.1108/03074351111167884