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American option evaluations using higher moments

Patrice Gaillardetz (Department of Mathematics and Statistics, Concordia University, Montreal, Canada)
Saeb Hachem (Maxiquest, Concordia University, Montreal, Canada)

Studies in Economics and Finance

ISSN: 1086-7376

Article publication date: 21 November 2023

Issue publication date: 14 November 2024

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Abstract

Purpose

By using higher moments, this paper extends the quadratic local risk-minimizing approach in a general discrete incomplete financial market. The local optimization subproblems are convex or nonconvex, depending on the moment variants used in the modeling. Inspired by Lai et al. (2006), the authors propose a new multiobjective approach for the combination of moments that is transformed into a multigoal programming problem.

Design/methodology/approach

The authors evaluate financial derivatives with American features using local risk-minimizing strategies. The financial structure is in line with Schweizer (1988): the market is discrete, self-financing is not guaranteed, but deviations are controlled and reduced by minimizing the second moment. As for the quadratic approach, the algorithm proceeds backwardly.

Findings

In the context of evaluating American option, a transposition of this multigoal programming leads not only to nonconvex optimization subproblems but also to the undesirable fact that local zero deviations from self-financing are penalized. The analysis shows that issuers should consider some higher moments when evaluating contingent claims because they help reshape the distribution of global cumulative deviations from self-financing.

Practical implications

A detailed numerical analysis that compares all the moments or some combinations of them is performed.

Originality/value

The quadratic approach is extended by exploring other higher moments, positive combinations of moments and variants to enforce asymmetry. This study also investigates the impact of two types of exercise decisions and multiple assets.

Keywords

Acknowledgements

The authors are very grateful to the referees for their valuable comments and suggestions. This research was supported by the Natural Sciences and Engineering Research Council of Canada.

Citation

Gaillardetz, P. and Hachem, S. (2024), "American option evaluations using higher moments", Studies in Economics and Finance, Vol. 41 No. 5, pp. 981-997. https://doi.org/10.1108/SEF-08-2023-0458

Publisher

:

Emerald Publishing Limited

Copyright © 2023, Emerald Publishing Limited

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