Pricing and hedging American options in incomplete markets

Abstract

Purpose

This paper sets out to consider the problem that the initial value of the American option is less than its fair price; this implies that the replication portfolio does not exist in the market.

Design/methodology/approach

The paper develops an optimization model whose solution provides an optimal strategy for the writer to minimize the expected loss for this problem.

Findings

The numerical results reveal that loaning money to construct a replication portfolio may not be an optimal strategy for the writer.

Practical implications

The solution of the minimum expected loss model provides an optimal strategy to construct a lower expected loss portfolio.

Originality/value

The numerical results reveal that loaning money to construct a replication portfolio may not be an optimal strategy for the writer.

Citation

Liu, H. and Long Liu, M. (2009), "Pricing and hedging American options in incomplete markets", Journal of Modelling in Management, Vol. 4 No. 1, pp. 72-82. https://doi.org/10.1108/17465660910943766