, Volume 14, Issue 3, pp 283-332

American options and callable bonds under stochastic interest rates and endogenous bankruptcy

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Abstract

A new characterization of the American-style option is proposed under a very general multifactor Markovian and diffusion framework. The efficiency of the proposed pricing solutions is shown to depend only on the use of a viable valuation method for the corresponding European-style option and for the transition density of the model’s state variables. Under a Gauss-Markov stochastic interest rates setup, these new American option pricing solutions are shown to offer a much better accuracy-efficiency trade-off than the approximations already available in the literature. This result is also used to price callable corporate bonds under an endogenous bankruptcy structural approach, by decomposing the option to call or default into a European put on the firm value plus two early exercise premium components.

Financial support by Fundação Ciência e Tecnologia’s grant number PTDC/EGE-ECO/099255/2008 is gratefully acknowledged.