Pricing American Options using Simulation

American options are financial contracts that allow exercise at any time until ex- piration. While the pricing of standard American option contracts has been well researched, with a few exceptions no analytical solutions exist. Valuation of more in- volved American option contracts, which include multiple underlying assets or path- dependent payoff, is still to a high degree an uncharted area. Most numerical methods work badly for such options as their time complexity scales exponentially with the number of dimensions. In this Master’s thesis we study valuation methods based on Monte Carlo sim- ulations. Monte Carlo methods don’t suffer from exponential time complexity, but have been known to be difficult to use for American option pricing due to the forward nature of simulations and the backward nature of American option valuation. The studied methods are: Parametrization of exercise rule, Random Tree, Stochastic Mesh and Regression based method with a dual approach. These methods are evaluated and compared for the standard American put option and for the American maximum call option. Where applicable the values are compared with those from deterministic reference methods. The strengths and weaknesses of each method is discussed. The Regression based method essentially reduces the problem to one of selecting suitable basis functions. This choice is empirically evaluated for the following Amer- ican option contracts; standard put, maximum call, basket call, Asian call and Asian call on a basket. The set of basis functions considered include polynomials in the underlying assets, the payoff, the price of the corresponding European contract as well as certain analytic approximation of the latter. Results from the empirical studies show that the regression based method is the best choice when pricing exotic American options. Furthermore, using available analytical approximations for the corresponding European option values as a basis function seems to improve the performance of the method in most cases.