Review of Derivatives Research

, Volume 7, Issue 2, pp 129–168

Assessing the Least Squares Monte-Carlo Approach to American Option Valuation

  • Lars Stentoft
Article

DOI: 10.1023/B:REDR.0000031176.24759.e6

Cite this article as:
Stentoft, L. Review of Derivatives Research (2004) 7: 129. doi:10.1023/B:REDR.0000031176.24759.e6

Abstract

A detailed analysis of the Least Squares Monte-Carlo (LSM) approach to American option valuation suggested in Longstaff and Schwartz (2001) is performed. We compare the specification of the cross-sectional regressions with Laguerre polynomials used in Longstaff and Schwartz (2001) with alternative specifications and show that some of these have numerically better properties. Furthermore, each of these specifications leads to a trade-off between the time used to calculate a price and the precision of that price. Comparing the method-specific trade-offs reveals that a modified specification using ordinary monomials is preferred over the specification based on Laguerre polynomials. Next, we generalize the pricing problem by considering options on multiple assets and we show that the LSM method can be implemented easily for dimensions as high as ten or more. Furthermore, we show that the LSM method is computationally more efficient than existing numerical methods. In particular, when the number of assets is high, say five, Finite Difference methods are infeasible, and we show that our modified LSM method is superior to the Binomial Model.

American options Monte Carlo simulation Least Squares Monte-Carlo multiple underlying assets 

Copyright information

© Kluwer Academic Publishers 2004

Authors and Affiliations

  • Lars Stentoft
    • 1
  1. 1.School of Economics and ManagementUniversity of AarhusAarhus CDenmark

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