American options and stochastic interest rates

Abstract

AbstractWe study finite-maturity American equity options in a stochastic mean-reverting diffusive interest rate framework. We allow for a non-zero correlation between the innovations driving the equity price and the interest rate. Importantly, we also allow for the interest rate to assume negative values, which is the case for some investment grade government bonds in Europe in recent years. In this setting we focus on American equity call and put options and characterize analytically their two-dimensional free boundary, i.e. the underlying equity and the interest rate values that trigger the optimal exercise of the option before maturity. We show that non-standard double continuation regions may appear, extending the findings documented in the literature in a constant interest rate framework. Moreover, we contribute by developing a bivariate discretization of the equity price and interest rate processes that converges in distribution as the time step shrinks. This discretization, described by a recombining quadrinomial tree, allows us to compute American equity options’ prices and to analyze their free boundaries with respect to time and current interest rate. Finally, we document the existence of non-standard optimal exercise policies for American call options on a non-dividend-paying equity.