Abstract.
This paper studies the valuation of American options in the presence of external/non-hedgeable event risk. When the event occurs, the American option is terminated and a rebate is paid instead of the promised pay-off profile. Consequently, the presence of event risk influences the exercise strategy of the option holder. For the financial market in a diffusion setting, the probabilistic structure in terms of equivalent martingale measures is briefly analysed. Then, for a given equivalent martingale measure the optimal stopping problem of the American option is solved. As a main result, no-arbitrage bounds for American option values in the presence of event risk are derived, as well as hedging strategies corresponding to the no-arbitrage bounds.
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Received: May 2004,
Mathematics Subject Classification:
90C47, 60H30, 60G40
JEL Classification:
G13, D52, D81
The author thanks John Gould and Ross Maller for useful discussions. The author is also grateful to a referee for helpful comments. This research was partially supported by University of Western Australia Research Grant RA/1/485.
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Szimayer, A. Valuation of American options in the presence of event risk. Finance and Stochastics 9, 89–107 (2005). https://doi.org/10.1007/s00780-004-0141-8
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DOI: https://doi.org/10.1007/s00780-004-0141-8