UTEE #1136014, VOL 0, ISS 0

American option pricing by a method of error correction

scar Gutirrez

QUERY SHEET
This page lists questions we have about your paper. The numbers displayed at left can be
found in the text of the paper for reference. In addition, please review your paper as a whole
for correctness.

Q1. Au: Please confirm whether name and affiliation are correct as set.
Q2. Au: Please provide complete mailing address for correspondence, including street
address and zip/postal code.
Q3. Au: Please spell out CEV.
Q4. Au: Please add Broadie and Detemple to the references.
Q5. Au: Please provide Table 2 and 3.
Q6. Au: Please provide heading for first column and confirm whether table is correctly
aligned as set.
Q7. Au: Please spell out GBM.
Q8. Au: Please provide location for reference Cox, 1975.

TABLE OF CONTENTS LISTING

The table of contents for the journal will list your paper exactly as it appears below:

American option pricing by a method of error correction

scar Gutirrez
 THE ENGINEERING ECONOMIST
, VOL. , NO. ,
http://dx.doi.org/./X..

American option pricing by a method of error correction

scar Gutirrez
Department of Business Economics, Universidad Autnoma de Barcelona, Barcelona, Spain

Q1

ABSTRACT
The real options approach often assumes that investment projects
last indefinitely, which is an unrealistic assumption. When projects
live finitely, valuation techniques from American option pricing are
required. This article presents a method for pricing American options
based on the first-passage approach to the problem. The key is to
correct the error associated with the price obtained from a rough
first approximation. The procedure leads to a significant reduction
in error corresponding to the initial approximation. As a particular
case of the method proposed, we derive a closed-form approxima-
tion of the option price. The existence of a closed-form approxi-
mating formula (that does not involve iterative methods) keeps the
computational cost low. In terms of accuracy, the method can be
compared to much more sophisticated methods. A tight lower bound
(given in closed form) is also provided. The method is fast, accurate,
flexible, and easy to implement. A spreadsheet suffices for practical
implementation.

Introduction
From several points of view, the valuation of American options remains as a prominent, open
question in financial economics. Since the seminal articles where their European counterparts
were priced by means of a simple formula blind to investors preferences (Black and Scholes
5 1973; Merton 1973), notable theoretical and computational progress has shed light on the
problem. Despite these advances, the valuation of American options has not been satisfacto-
rily solved heretofore, still attracting researchers from both finance and mathematics. Aside
from the intellectual challenge, given that the optimal design and management of options
portfolios requires processing a huge amount of data in real time, the development of effi-
10 cient American option pricing methods is a relevant issue because most traded options are
American-style contracts. In addition, the computation of implied volatilities from American
options prices still remains unsolved, so the development of simple methods for American
option pricing is valuable (on the computation of implied volatilities in the European case,
see Li [2008] and references therein).
15 Furthermore, a deeper understanding of the valuation of American options can help
to explain outlay decisions, a question vastly analyzed in the real options literature. This

CONTACT Dr. scar Gutirrez oscar.gutierrez@uab.es Department of Business Economics, Universidad Autnoma de
Barcelona, Campus de Bellaterra, Cerdanyola, Barcelona, Spain.
Supplemental materials can be found online at http://dx.doi.org/./X...
Institute of Industrial Engineers
Q2
2 . GUTIRREZ

approach explains managerial flexibility as a source of value creation and represents a useful
tool in corporate planning analyses; see C. S. Park and Herath (2000), Herath and Park (2002),
Miller and Park (2002), and Trigeorgis (2005) for a review of the real options approach from
an engineering economics perspective.1 20
For the traditional real option to postpone investments, however, it is often assumed that
the option life is infinite, an assumption mainly made for the sake of simplicity (the model
can then be explicitly solved). This assumption represents a limitation, and the case where
investment projects do not last indefinitely remains a pending question. In Majd and Pindycks
words, 25

There are few real projects that last forever [ ]. In principle, future investments (e.g., main-
tenance) can be made to maintain the productivity of the project indefinitely. [ ] But not all
projects can be made to last forever by appropriate future maintenance investments. For exam-
ple, most natural resource projects have finite lives because there is a finite quantity of reserves
in the ground. (1987, p. 15) 30

Grasselli (2011, pp. 740741) stresses this point:

Most of the standard literature in real options is based on one or both of the following unrealistic
assumptions: (i) that the time horizon for the problem at hand is infinite and (ii) that the real
asset under consideration is perfectly correlated to a traded financial asset. [ ] Several authors
have dropped the artifice of an infinite time horizon and used standard numerical methods to 35
deal with the corresponding non-stationary valuation problem.

This could be one of the reasons of why the real options paradigm, although well settled from
a theoretical point of view, is not generally used by managers in capital budgeting analysis.
Block (2007) documents that only a small percentage of them (about 14%) use real options to
complement the classic net present value analyses. 40
It must be mentioned that finitely living projects have been considered in some papers.
Dixit and Pindyck (1994, ch. 5) consider a model where the demand can suddenly fall to zero
(which contrasts with American options traded in financial markets, where time to expiration
is known). Bunch and Johnson (2000, 1) establish a link between finite and infinite American
options. Carr (1998) considers a sequence of stochastic times to expiration, recovering the 45
American put value by making the sequence converge to a Diracs delta (i.e., fixed expiration
time) as a model parameter approaches infinity. The option price can thus be approximated
by means of Richardson extrapolation.
Finally, having tractable option pricing models can be useful in exploring the determi-
nants of investment and value creation; for example, to analyze how uncertainty affects 50
investment, an important issue in the real options literature (see Gutirrez 2007; Kanni-
ainen 2009; Sarkar 2000; Wong 2007). A related question is whether real option values
increase with higher volatility (of the underlying asset price), an unresolved question for Davis
(2002).
The first solutions to the American option pricing problem were numerical (Brennan 55
and Schwartz 1977; Cox et al. 1979). Unfortunately, numerical methods consume too much
time, which represents a problem when the relevant information must be processed in real
time. Given the existing trade-off between speed and accuracy, for many (academic and
industrial) applications it can be worth sacrificing some accuracy for speed. The array of
methods proposed to solve the problem is wide and varied. Several papers contain good 60

In addition to the real option of postponing investments, other real options have been analyzed in the investment literature:
the option to abandon (Berger et al. ; Dixit and Pindyck ), the option to expand capacity (Bollen [] and Kogut
[] in a product life cycle context), and the option to replace assets (Zambujal-Oliveira and Duque ).
 THE ENGINEERING ECONOMIST 3

reviews, so we refer the interested reader to Huang et al. (1996), Ju (1998), or Barone-Adesi
(2005).
Our purpose is to develop an accurate pricing method that fulfills the usual demands of
accuracy at the cost of computing a closed-form expression or a similarly tractable mathe-
65 matical object. The method rests on the use of the first-passage approach, an interesting pos-
sibility pointed out many years ago but little used to date. In fact, financial research has hardly
appealed to this approach, often unmentioned in the reviews of the topic. Some exceptions
are Omberg (1987), Bjerksund and Stensland (1993), and Gutirrez (2013). Another contri-
bution that uses the first-passage approach is Bunch and Johnson (2000), but this paper rests
70 much more on the early exercise premium integral representation than in the first-passage
approach (FPA). Some advantages of using the FPA to price options are made clear in the real
options context. The computation of the option value of waiting is strikingly simple when the
FPA is invoked: we just have to evaluate the moment-generating function associated with the
first-passage time of the Brownian motion to the (constant) optimal boundary at the interest
75 rate (recall that, in the perpetual case, the optimal boundary is constant). Furthermore, the
use of binomial trees is inadequate in the perpetual case since the option lives indefinitely.
In the following section we use approximate first-passage densities to propose a very simple
methodology that allows us to filter out the error of option prices when an approximate exer-
cise boundary substitutes for the optimal one. Then, a very improved approximation to the
80 option price is obtained. An advantage of the method is that the approximate exercise bound-
ary does not need to be very accurate. In the next section, we select a particular specification
of the method to obtain a closed-form approximation to the American option value. Apart
from the pedagogical value of the closed form, approximating the option price by means of
an analytical expression (without iterative procedures involved) makes the method extremely
85 fast, which is important from the practical point of view. In terms of accuracy, the method
can be compared to methods much more sophisticated and computationally demanding. For
example, the method performs better than a binomial tree of 150 steps, the methods by Ju and
Zhong (1999) and Longstaff and Schwartz (2001), and some implementations of the recursive
scheme of Huang et al. (1996) and Carr (1998). Moreover, the method is very simple to imple-
90 ment; a spreadsheet suffices for its practical implementation. The method proposed does not
provide a lower bound to the option price (nor an upper one), so it may be interesting to
indicate the sign of the price error. Then, a tight lower bound is provided (Proposition 1).
Numerical results and comparisons are presented in the next section, and the final section
summarizes the main conclusions of the article.

95 The method
We center our attention on the American put with non-dividend-paying stock. The exten-
sion to the case of a positive dividend rate (when the dividend yield is not above the interest
rate) is considered below.2 For the sake of simplicity, we assume that price uncertainty is
driven by a Brownian motion, but the method proposed can be extended to other continu-
100 ous processes with a known transition density (for example, the CEV process proposed by Q3
Cox [1975]). From now on, the following notation will be used:The option expires at t = T,
where t [0, T ] denotes the time variable; St denotes the stock price at time t. It solves the

We provide the put price without loss of generality. The call-put parity (McDonald and Schroder ) can be invoked for
continuously compounded constant dividends.
4 . GUTIRREZ

standard Black-Merton-Scholes one-dimensional stochastic differential equation. The proba-

bility measure is the (standard in option pricing) risk-neutral measure, say Q. The information
structure is specified by the standard filtration, the one generated by the Wiener process that 105
determines the stock price under the risk-neutral measure, WtQ , denoted by Wt from now
on. As is well known, the Wiener process is a particular Markovian diffusion. K is the strike
price of the option; r represents the risk-free interest rate; represents the constant instanta-
neous volatility of returns, assumed constant; and pT denotes the European put price at t =
0. Expiration occurs at t = T, so the European put valued at t has a price noted by pT t (St ). 110
PT denotes the American put price at t = 0; Bt represents the optimal exercise bound-
ary; (t ) represents an arbitrary, approximate exercise boundary; g (t ) (t ) represents the first-
passage density of St to boundary (t ); ha(t ) (t ) represents the first-passage density of Wt
to the curved barrier a(t); finally, PT (M| ) represents the approximation to PT obtained
under method M using the approximate boundary (t ). In this article, method M can be the 115
first-passage approachthat is, FPAor the integral representation of early exercise premium
(EEP; see Carr et al. 1992; Jacka 1991; Jaekel 2005; or Kim 1990).
The American put price appealing to the FPA is written as
 T  T
rt
PT (FPA) = max e (K (t ))g (t ) (t )dt ert (K Bt )gBt (t )dt. (1)
(t ) 0 0

The density function g (t ) (t ) can be related to the first-passage density of a Brownian

motion to an absorbing barrier, a question analyzed in detail in the probabilistic literature. 120
In our context, the absorbing barrier a(t), which belongs to the Wt -space, and the exercise
boundary (t ), which belongs to the St -space, are linked by the equation3

a(t ) = (1/ )[log( (t )/S0 ) (r 2 /2)t] (2)

2
(Conversely, (t ) = S0 e(r /2)t a(t ) .)
Next, we describe a pricing method based on correcting the error associated with a first
approximation of the option price:In first place, a sensible approximation to the optimal exer- 125
cise boundary, expressible in closed form, is needed. Examples of approximate boundaries
adopting simple expressions can be found in Bunch and Johnson (2000), Carr et al. (1992),
or Li (2010). If compared to other methods (for example, EEP), the option price obtained by
FPA is hardly sensitive to the approximating boundary; see below.
Second, an expression for the first-hitting density is required. In order to compute the 130
first-passage density, several methods have been proposed (Buonocore et al. 1987; Durbin
1992; Park and Schuurmann 1976; Ricciardi et al. 1984, among others; see Peskir [2002] for a
review). Our method, however, does not require an exact representation of the first-passage
density but rather an approximation. Approximations of first-passage densities can be found
in Daniels (1996), who proposes the use of images; Durbin (1992), who, beginning with the 135
tangent approximation, derives a series expansion of integrals with increasing dimensionality
that converges to the true density; or the hazard rate approximation of Roberts and Shortland
(1995). In some cases, the approximation of the first-passage density demands some condi-
tions regarding the absorbing barrier (and in our case, consequently, regarding the approxi-
mate exercise boundary). For example, Durbin (1992) demands a continuously differentiable 140

If the state variable x follows a Wiener process, any probability density function f(x, t) satises the following partial dierential
2
1 f f
equation: 2 x2 t = 0 (with adequate boundary conditions). The relation between the probability density function and
f (x,t )
the rst-passage density to an absorbing barrier a(t) > , ga(t ) is given by ga(t ) = (1/2)limxa(t ) x .
 THE ENGINEERING ECONOMIST 5

barrier, whereas Roberts and Shortland (1995) demand a barrier twice-continuously differ-
entiable. Once an approximation to the first-passage density fAPPROX
(t ) (t ) has been chosen, the
first approximation (F.A.) to the put price is given by
 T
PTF.A. (FPA| ) := ert (K (t )) fAPPROX
(t ) (t )dt. (3)
0

From now on, when there is no confusion about the approximate boundary, we denote
 T rt
145 PTF.A. (FPA| ) by PTF.A. and pF.A.
T (FPA| ) := 0 e pT t ( (t )) fAPPROX
(t ) (t )dt by pF.A.
T .
F.A.
The fact that pT and pT differ will allow us to correct the initial error and get an improved
price. For that purpose, we use the following result:

Lemma 1. Let (t) be a continuous boundary in (0, T) such that:

(i) (0) < S0 ; (ii) (T) K. Then, the European put price can be expressed as
 T
pT = ert pT t ( (t ))g (t ) (t )dt. (4)
0

150 Proof. Consider a financial claim that pays the amount pT t ( (t )) when the stock price first
hits barrier (t), with 0 t T. Under risk-neutral probability, the price of this financial
T
instrument must be 0 ert pT t ( (t ))g (t ) (t )dt.

On the other hand, Black and Scholes (1973) demonstrate that any option value f must
be the solution to the problem associated with the partial differential equation (PDE)
155 (1/2) 2 x2 fxx + rx fx r f ft = 0 with adequate boundary conditions. In the present case,
these conditions are

f ( (t ), t ) = pT t ( (t ))
f (x, t = T ) = (K x)+

(i.e., the condition associated with the American put, f ( (t ), t ) = K (t ), is substituted

by f ( (t ), t ) = pT t ( (t ))).
Given that both Pt and pt satisfy the Black-Scholes PDE, the solution to this problem can
160 be expressed as f (S, T t ) = pT t (S) + eT t (S), where function eT t satisfies the Black-
Scholes PDE with boundary condition eT t (S = (t )) = 0. Therefore, eT t is the value of a
financial claim with zero value at the boundary and zero value if the boundary is not reached,
which implies that eT t = 0 for an arbitrarily chosen boundary (t). It follows that function
et must be equal to zero, so fT = pT , and Equation (4) holds.
165 We have imposed condition (ii) (T) K in order to guarantee the existence of the first-
passage density to the approximate boundary, because Durbin (1990, p. 292) demands a con-
tinuously differentiable barrier.
Third, the first approximation to the option price PTF.A. is corrected as follows:
1. Let us consider a family of functions fAPPROX
(t ) (t; ) that includes fAPPROX
(t ) (t ) as a par-
170 ticular case. The family is parameterized by , a real number, and there must exist a
feasible value 0 such that fAPPROX
(t ) (t; 0 ) fAPPROX
(t ) (t ).
2. From this family of densities, we choose the particular one for which the following
equation holds (see Lemma 1):
 T
pT = ert pT t ( (t )) fAPPROX
(t ) (t; )dt.
0
6 . GUTIRREZ

Then, we search for the parameter value:

  T 
= arg pT ert pT t ( (t )) fAPPROX
(t ) (t; )dt = 0 , (5)
0

ensuring ourselves that (i) the boundary satisfies the regularity conditions demanded by the 175
particular approximation method used and (ii) the equation between brackets has at least one
solution. From the practical point of view we must observe that, for some particular specifi-
cations, the existence of a solution entails no problem (see next section).
Now we replace fAPPROX
(t ) (t ) by fAPPROX
(t ) (t; ), which yields a significant improvement in
accuracy (the error corresponding to the first approximation has been substantially reduced). 180
Observe that fAPPROX
(t ) (t; ) does not necessarily represent a good approximation to g (t ) (t )
(for example, under the least squares criterion). However, in our option pricing context the
approximation works very well.
Fourth (and finally), we approximate put price PT by
 T

PT PT (FPA| ) := ert (K (t )) fAPPROX
(t ) (t; )dt, (6)
0

an approximation denoted by PT when there is no possible confusion concerning the approx- 185
imate boundary. This approach yields very accurate prices, performing even better than more
sophisticated (and complex to implement) methods.4 We recall that the approximate price
given in Equation (6) is neither a lower bound nor an upper one of the option price.
It must be remarked that the method is valid whenever the approximate boundary is equal
to (or greater than) K at expiration; that is, whenever the probability of reaching the boundary 190
is equal to one. Otherwise, the density function of the stock price at expiry, f (t ) (S, T ) with
S (T ), must be taken into account. Therefore, the dividend yield must not exceed the
interest rate (otherwise, the optimal exercise boundary at T is below K, a property that the
approximate boundary should also satisfy).
One example: Consider the following (multiplicatively separable) specification for the den- 195
sity approximation: hAPPROX
a(t ) (t; ) = et hTA
a(t ) (t ), where f (t ) (t ) represents the so-called tan-
TA

gent approximation (TA) to the first-passage density (see Durbin 1992). Obviously, in this
case 0 = 0. Let us use the approximate boundary of equation (19) in Bunch and Johnson
(2000). For concave boundaries, TA overestimates true density. The overestimation increases
as t increases, and factor et dampens the overestimation. For the option with S0 = K = 40, 200
= 0.4, r = 0.0488, and T = 4 months, the first approximation to the option price, see Equa-
tion (3), is 3.628. The value of that solves Equation (5) is = 0.297. The corrected approx-
imate price, see Equation (6), is 3.385. An accurate estimation of the option price (obtained
by means of a binomial tree with 10,000 steps) is 3.387.

A closed-form approximation 205

In this section, a closed-form approximation is provided for the option price by adopting very
simple specifications in the method proposed above. In particular, we assume the following:
1. The approximate boundary is taken from Carr et al. (1992, p. 93):
K
(t ) = [ + e T t ], (7)
1+
For example, Geske and Johnson (); the four-point and six-point schemes of Huang et al. (); or Longsta and Schwartz
(). Also Carr () and Ju () if extrapolation is not used (without extrapolation, both methods substantially worsen,
being beaten by much simpler methods).
 THE ENGINEERING ECONOMIST 7

with = 2r/ 2 and a positive constant (about 1.3).5 This boundary interpolates
210 the perpetual case ( B = 1+
K
; see Merton 1973) and an approximation to the behav-

ior of the optimal boundary at expiration( (t T ) = Ke T t ; see Van Moerbeke
1976). The link between the approximate boundary (t ) and the absorbing barrier
a(t) is given in Equation (2). Because the probability literature usually analyzes the
first-passage problem under the Brownian motion assumption, we will use ha(t ) (t ),
215 the first-passage density of a Brownian motion to barrier a(t), instead of g (t ) (t ), the
first-passage density of the stock price (a geometric Brownian motion) to boundary
(t ). The two probability measures are related by ha(t ) (t )dt = g (t ) (t )dt.
2. For approximating the first-passage density, hAPPROX
a(t ) (t ), we take the first two terms of
the series expansion of Durbin (1992); that is,
 2 
1/2 a (t )
hAPPROX
a(t ) (t ) = b(t )(2t ) exp , (8)
2t
220 where
 t  
a(t ) a(t ) a(t ) a(s)
b(t ) = a
(t ) a
(t ) a
(s) f (s|t )ds
t 0 t t s
and
 
1 1 [a(s) a(t )s/t]2
f (s|t ) = exp
2s(1 s/t ) 2 s(1 s/t )
This specification corrects the tangent approximation, which corresponds to the case
where b(t ) = a(tt ) a
(t ). The tangent approximation works well when the absorbing
barrier has a low curvature, but in the option pricing context the absorbing barrier has
225 a high curvature as expiration approaches (recall that Durbins [1992] representation
demands that barrier a(t) must be continuously differentiable in (0, T)). As expira-
tion approaches, the approximate first-passage density to the boundary given in Equa-
tion (7) tends to infinity, whereas K (t ) tends to zero. Although it can be shown
that the product (K (t ))hAPPROX
a(t ) (t ) tends to a finite number, it is easier to evaluate
230 it at T with a very small positive number.
3. Assume that fAPPROX
(t ) (t; ) = fAPPROX
(t ) (t ). In this case, the existence of a solution to
Equation (5) is guaranteed, and is simply reduced to

pT pT
= T F.A. . (9)
0
ert pT t ( (a(t )))hAPPROX
a(t ) (t )dt pT

(The existence of is easily proven in the geometric Brownian motion case, because
both pT and pF.A.
T exist and are finite. The existence of the European put price, pT , is
235 guaranteed from the Black and Scholes [1973] model. The existence of pF.A. T is guar-
anteed appealing to Durbin [1992] and it is finite because pF.A.T < p T . When other

processes drive the stock price dynamics, the existence of is guaranteed if the Euro-
pean put price and the transition density function are known; both conditions are met
under the CEV process.)
240 This number is above one and corrects the first approximation of the option price, PTF.A. .
The correction leads to a particular approximation of the option price expressible in closed
The optimal boundary when K = , = ., r = ., and T = / is . (see Bunch and Johnson , table ). Substituting
this value in Equation (), we obtain = ., which, rounded up, gives ..
 8 . GUTIRREZ

form:
 T
PT PT =
2 /2)t a(t )
ert (K S0 e(r )hAPPROX
a(t ) (t )dt, (10)
0

with given in Equation (9); a(t) calculated by inserting Equation (7) in Equation (2); and
hAPPROX
a(t ) (t ) calculated from Equations (Equation (8). More succinctly, the corrected approxi-
mating price can be written as PT = P F.A. . It seems obvious that 10) (in general, Equation (6)) 245
T
should give more accurate prices than Equation (3). Although all of our numerical experi-
ments confirm this intuition, we cannot offer formal proof for it. In the following section we
provide another approximation, a lower bound, that is shown to be more accurate than PTF.A. .
The method permits further improvements in two directions: to gain accuracy and to gain
speed. We can get higher accuracy by making a good choice of parameter in Equation (7). 250
For example, can be selected to maximize the value of the lower bound given in the next
section. In order to gain speed, the TA to the first-passage density can be used. In addition, we
can use the second-order approximation evaluated in a small number of points, interpolating
the rest. This kind of simplification can yield a drastic reduction of the computational burden.
The model can be easily extended to the case of a constant, positive dividend rate when it 255
does not exceed the interest rate (recall that the method is valid whenever the approximate
boundary is equal to or greater than K at expiration; see Method section).6 In the case r d,
the model is extended as follows:
1. The approximate boundary must take into account the dividend payout, so =
2r/

2
in Equation (7) must be substituted by = (1/2 ((r d)/ 2 ) + 260
(1/2 ((r d)/ 2 )2 + 2r/ 2 .
2. The European put values contained in the formulae, see Equation (9), must include
the dividend rate.
3. In functions a(t) and a
(t), see Equation (2), the dividend rate must be taken into
account: r must be substituted by r d, and the approximate boundary must also be 265
adjusted (see Point 1 above).
The performance of the method can be seen in Table 1. The method performs better than
does a binomial tree with 150 steps, without requiring recursive procedures (see Numerical
Illustration). It must be observed that Equation (10) involves integrals whose integrands con-
tain the approximate density function (expressed as an integral, see Equations (Equation (8)) 270
Q4 and normal cumulative distribution functions. However, all computations can be simultane-
ously performed, whereas binomial trees involve computations carried out sequentially. The
method also performs better than lower bound approximation (LBA; not lower and upper
bound approximation) of Broadie and Detemple (1996) something to be expected taking into
account that our first approximation is much more accurate than is the lower bound used 275
in LBA. We can see the approximate option price, Equation (10), as the product of the first
approximation to the option price( PTF.A. )times a factor ( ) that corrects the error due to using
an approximation to the first-passage density. The correction is based on the fact that the true
T
value of 0 ert pT t ( (t ))g (t ) (t )dt is precisely known (it is the European put price).
Q5 The parameters are specified in Table 1, except S0 = 40 and r = 0.0488. The prices cor- 280
responding to the first three methods have been taken from table 2 in Bunch and Johnson
(2000): The first one corresponds to a binomial tree with 10,000 steps. The second one corre-
sponds to a binomial tree with 150 steps. The third one is an implementation of EEP with the
Furthermore, if d > r, the optimal boundary is not convex everywhere (see Chen et al. ), and we need a convex boundary
in order to obtain a lower bound for the option price (see next section).
 THE ENGINEERING ECONOMIST 9

Table . American put prices.

Q6
K =
= . = . = .
T= T= T= T= T= T= T= T= T=

BT (,) . . . . . . . . .
BT () . . . . . . . . .
EEP . . . . . . . . .
Ju-Zhong . . . . . . . . .
ABEC . . . . . . . . .
LBBEC . . . . . . . . .
K =
BT (,) . . . . . . . . .
BT () . . . . . . . . .
EEP . . . . . . . . .
Ju-Zhong . . . . . . . . .
ABEC . . . . . . . . .
LBBEC . . . . . . . . .
K =
BT (,) . . . . . . . . .
BT () . . . . . . . . .
EEP . . . . . . . . .
Ju-Zhong . . . . . . . . .
ABEC . . . . . . . . .
LBBEC . . . . . . . .

boundary given by Equation (7). The fourth one corresponds to Ju and Zhong (1999), method
285 MQuad. The fifth corresponds to the method proposed in this article, Equation (10). The last
one is the lower bound given in Proposition 1.
Approximation based on error correction (ABEC) and lower bound based on error cor-
rection (LBBEC) can face difficulties when pricing options deep in the money (which are not
traded very often). In order to avoid this kind of problem, when the approximate optimal
290 boundary is above the initial stock price ( (0) > S0 ), the option value is set equal to K S0 ,
and if K S0 > PT , the approximate option price is also taken to be equal to K S0 . This
has been used to price the option with K = 45, T = 1, and = 0.2 under ABEC, an option
not priced by LBBEC.

A lower bound
295 The following result provides a lower bound for the American put price.

Proposition 1. Consider the approximation to the first-passage density given in Equations (8).
Let be a boundary satisfying conditions (i) and (ii) in Lemma 1, with log( ) strictly convex in
(0, T) and such that pT t ( (t )) K (t ).
Then, PT is bounded from below by PTL.B. := PTF.A. + pT pF.A.
T .

300 Proof. The FPA price is a lower bound ofPT (unless (t ) = Bt in all subsets of [0, T] with
T
a positive measure): PT PT (FPA| ) := 0 ert [K (t )]g (t ) (t )dt.
T
By Lemma 1, pT = 0
ert pT t ( (t ))g (t ) (t )dt, so
 T  T
PT pT ert [K (a(t ))]ha(t ) (t )dt ert pT t ( (a(t )))ha(t ) (t )dt
0 0
10 . GUTIRREZ

Durbin (1992) shows that, if the barrier is strictly concave with a(0) > 0, then his sec-
ond approximation represents a strict lower bound (see Durbins equations (6) and (7)).
Because log( ) is strictly convex by assumption and log( (0)/S0 ) < 0 (because (0) < S0 ; 305
see Assumption (i) in Lemma 1), barrier a(t ) = (1/ )[log( (t )/S0 ) (r 2 /2)t] is
strictly concave in (0, T) with a(0) > 0. Therefore, Durbin (1992) ensures that inequality
hAPPROX
a(t ) < ha(t ) holds. As by assumption inequality K (t ) pT t ( (t )) holds, we can
T
ensure that PT pT > 0 ert [K (a(t )) pT t ( (a(t )))]hAPPROX
a(t ) (t )dt = PTF.A. pF.A.
T ,
so PT + pT pT < PT , QED.
F.A. F.A.
 310
We have demanded that the logarithm of the approximate boundary is convex, a prop-
erty also satisfied by the optimal boundary; see Ekstrm (2004) or Chen et al. (2008). For
the particular case of the boundary given
in Equation (7), if we center our attention on the
time-dependent component, e(T t ) T t , we see that its logarithm is strictly convex. Two
interesting properties on PTL.B. are given next: 315

Proposition 2.
(a) PTL.B. is more accurate than PTF.A. .
(b) PTL.B. is lower than PT .

Proof.
(a) hAPPROX
a(t ) < ha(t ) implies that pF.A.
T < pT , so pT pT is positive and the lower bound 320
F.A.

PT := PT + pT pT is above PT . Given that both PTL.B. and PTF.A. are lower

L.B. F.A. F.A. F.A.

bounds, PTL.B. must be closer to PT .

(b) See below (however, it must be noted that PT is not necessarily a better approximation
than PTL.B. , see footnote 7). 

It is worth noting that the computation of PTL.B. implies no additional cost once PT has been 325
calculated. The lower bound obtained, PTL.B. = PTF.A. + pT pF.A. T , is very tight (see Table 1),
almost as accurate as Ombergs two-parameter exponential boundary implementation of FPA
(see table 1 and Chung et al. [2010], method labeled LB2). In some cases it performs even bet-
ter than LB2, with the advantage that no iterative procedures are required. Obviously, when
PTL.B. is above the price obtained from any other method, we can take PTL.B. as the better approx- 330
imation between those two approximate prices. This represents a simple way to improve the
accuracy of any approximating method, particularly useful when the errors of the method
have no definite sign, as is the case of binomial trees. If we use TA (instead of the second-order
approximation given in Equations (8)), the approximation is very accurate too, but prices lose
the property of being lower bounds. 335
The correction to PTF.A. is based on European prices, pT pF.A. T , an amount smaller than
its American counterpart PT PTF.A. (so PTL.B. is a lower bound). Then we could correct
pT pF.A. L.B.
T (upwards) to obtain a better approximation than PT ; for example, by multiplying
the initial correction pT pF.A. T by the factor PTF.A. /pF.A.
T ; that is, considering the following
approximation to PT : PT + (PT /pT )(pT pT ). In this case, it is easy to check that
F.A. F.A. F.A. F.A.
340
the approximate option price coincides with PT , the approximation given in Equation (10).
(Because PTF.A. /pF.A.
T is higher than 1, Proposition 2(b) is proven.) If we consider, instead, the
alternative approximation PT such that PT = PTF.A. + (PT /pF.A. T )(pT pT ), then PT = PT
F.A.
again.
T
In summary, pT and 0 ert pT t ( (t ))hAPPROX
(t ) (t )dt differ, and it is exactly that difference 345
that we have used to estimate the error associated with the first approximation ( PT PTF.A. ).
We approximate the error price by pT pF.A. T , which allows us to obtain a lower bound of the
 THE ENGINEERING ECONOMIST 11

option price. This bound is almost as accurate as the price calculated from the true density
function, which yields a drastic reduction in computational burden with a negligible loss of
350 accuracy. Sometimes, the lower bound gives even more accurate prices than do approxima-
tions taken as exact prices. If S0 = K = 1, = 0.5, r = 0.125, and T = 12 months, Geske and
Johnsons (1984) exact price is 0.1472. Our lower bound ( PTL.B. ) is 0.1474. If S0 = K = 40,
= 0.4, r = 0.06, and T = 12 months, the price calculated in Longstaff and Schwartz (2001) by
finite differences is 5.312, and PTL.B. is 5.316.
355 It is worth recalling that the error of approximating PT by PTL.B. has two sources: First,
we approximate option price PT by PT (FPA| ), which is the price of a barrier option that
pays K-S when the stock price hits barrier (t). Second, we estimate the barrier option price
by using an approximate density function instead of the true one. As the numerical examples
in next section suggest, the overall error is very small and can compete against the errors of
360 currently competitive methods. This is because (i) approximating PT by PT (FPA| ) is very
accurate because the option price is stationary in the optimal exercise boundary, so small
deviations from that boundary yield very small deviations from the exact option price; and
(ii) pT pF.A.T is a good approximation to PT (FPA| ) PTF.A. . Here are some numerical
examples: consider the three options with S0 = 100; K = 90, 100, and 110; T = 6 months;
365 = 0.3; and r = 0.07. The option prices obtained from binomial trees with 10,000 steps are
3.123, 7.035, and 12.955. Our lower bounds are 3.118, 7.028, and 12.947 ( = 1.3). If we select
to maximize the option prices, the lower bounds are 3.122, 7.032, and 12.950. Using the
approximate boundary in Equation (7) and the true density, which involves iterative proce-
dures, the prices of the options are 3.122, 7.032, and 12.951: these examples illustrate the fact
370 that taking an approximation to the true density (and correcting the error using the method
proposed) allows us to drastically reduce the computational cost with a negligible loss of
accuracy.
Finally, we wish to highlight that all of our numerical examples have been calculated using
MS Excel. The spreadsheet used is available as supplemental material on the publishers web-
375 site. Let us briefly explain the steps for practical implementation.
First, let us define column vectors (n-tuples, in our examples n = 200) describing time;
the approximate boundary (see Equation (7)); transformation a(t) (see Equation (2)) and its
derivative a
(t); and function b(t), which is required to compute the second-order approxima-
tion of the first-passage density to the approximate boundary (t), noted by hAPPROX a(t ) (t ) (see
380 Equations (8)).
Second, let us construct an (n + 1) (n + 1) matrix that represents function
a(t ) )a(s)
[ t a
(t )][ a(t ts a
(s)] f (s|t ), with t ranging from 0 to n and s ranging from 0 to t; see
Equation (8). The matrix is triangular, with zeros below the principal diagonal. This matrix is
needed to calculate function b(t); see above. The calculation of b(t) is performed by adding the
385 elements contained in the files of the matrix (this sum represents the second-order correction
to the tangent approximation in hAPPROX a(t ) (t )).
Third, ABEC and LBBEC prices are obtained by discretization (adding the elements of the
column vectors containing the discretized terms).

Numerical illustrations
390 In this section, we provide numerical illustrations on the performance of several option pric-
ing methods. Table 1 shows the prices of 27 American puts taken from Huang et al. (1996);
a different set of options, taken from Ju (1998), has also been priced (see below). Given our
demands of accuracy, some existing methods admitting closed-form approximations (e.g.,
12 . GUTIRREZ

Bjerksund and Stensland 1993; Johnson 1983) do not give fine-enough prices (in some cases
errors exceed 1%). The prices reported in Table 1 are obtained using six different methods, 395
the first two of which correspond to binomial trees (BTs) with 10,000 and 150 steps, respec-
tively; the first one is often taken as the exact price but, strictly speaking, it is an approximation
(an extremely good one for the degree of accuracy demanded in this field of research). The
third method represents the implementation of the early exercise premium method with the
boundary given in Equation (7) and represents a closed-form approximation. The fourth one 400
is the method by Ju and Zhong (1999), who improve the analytical valuation of MacMillan
(1986) and Barone-Adesi and Whaley (1987). The last two methods have been presented in
this article: the fifth one uses Equation (10) and is labeled ABEC. The last one corresponds to
the lower bound given in Proposition 1, PTL.B. , a method labeled LBBEC. We have taken =
1.3 in all cases. 405
The value of parameter has been deliberately chosen without much care ( = 1.3). The
intention was to show that the method performance does not crucially depend on a time-
consuming choice of (for example, the value that maximizes the lower bound PTL.B. ). If we
recalculate the option prices using = 1.27 (see Footnote 4) instead of 1.3, the differences
obtained are not appreciable (we report prices that include up to three decimals, and most of 410
the 27 prices does not change at all if we replace = 1.27 for 1.3; for appreciable differences
to appear, the fourth decimal must be included, and such a degree of accuracy is unneces-
sary in this context). Furthermore, it must be pointed out that = 1.27 is not necessarily
the best choice but rather only a sensible approximation. The choice 1.3 can also be
justified in the following manner:
the optimal exercise boundary can be written as B = 415
K exp((r + 2 /2) g ), where g represents the solution to an equation solvable by
appealing to numerical methods (see Bunch and Johnson 2000, equation 22). The value of g
is typically about 1.5 (see Bunch and Johnson 2000, p. 2341). If we equate B (with g 1.5)
to our Equation (7), then 1.3 represents a good approximation for typical parameter
values. 420
From Table 1, we observe that ABEC performs better than the rest. We have used the root
mean square error (RMSE) in comparison of the methods. The RMSE of ABEC is 1.7 103 ,
smaller than the RMSE of BT150 (2.6 103 ) and much smaller than the RMSE of EEP
(8.3 103 , which is slightly better than the EEP implementation of Bunch and Johnson
2000, equation (29)). In relative terms, ABEC clearly performs better than BT150 (0.053% 425
vs. 0.37%). Such a difference in the performances comparison is due to BT150 performing
better than ABEC for in-the-money options, where relative differences are smaller. For many
applications, BT150 is considered a sufficiently accurate method, but the many recursively
related computations of any binomial tree undermine its efficiency. It must be pointed out that
the maximum absolute error of ABEC (0.006) corresponds to an in-the-money option, within 430
the set of options where the method performs worse. If we only consider out-of-the-money
and at-the-money options, the most traded ones, the RMSEs of the 18 remaining options
are 2.8 103 (BT150) and 8.3 104 (ABEC). The last error is slightly above the error of
the non-approximating method of Bunch and Johnson 2000, equations (22) and (23)), where
errors are numerical (7.8 104 ). 435
Method LB2 in Chung et al. (2010; which corresponds to Ombergs [1987] method with
two free parameters) provides very accurate prices, always lower bounds, with an RMSE of 1.6
103 and relative error of 0.062%, but it requires a two-dimensional maximization involving
cumulative distribution functions. Our lower bound( PTL.B. , method LBBEC) also works very
well, with an RMSE of 2.5 103 . It represents one of the tightest lower bounds given in closed 440
form that can be found in the literature and avoids the use of iterative methods. If parameter
 THE ENGINEERING ECONOMIST 13

is selected to maximize the lower bound, LBBEC is more accurate than is LB2. In overall
terms, LBBEC with fixed (no iterative methods required) works slightly worse than does
LB2, although in some particular cases it performs better.7
445 If we use TA instead of the second-order approximation given in Equations (8), PTTA +
pT pTA T , option prices are rather accurate too, but they lose the property of being lower
bounds. The RMSE is 3.8 103 , and the relative error is 0.091%, with the advantage that
the computational cost using TA is drastically reduced (the dimensionality of the problem is
reduced in one dimension).
450 A faster method than BT150 is the one proposed by Ju and Zhong (1999). The Ju-Zhong
approximation is shown to be more accurate than are the less efficient methods of Geske and
Johnson (1984) and the four-point implementation of Huang et al. (1996); see Ju and Zhong
(1999, table 3). Although Ju-Zhong is very efficient because it admits analytical formulae,
option prices are written in terms of the critical stock price, whose computation requires iter-
455 atively solving an equation that involves cumulative distribution functions. We must observe
that the Ju-Zhong method is based on a simple approximation to the early exercise premium,
and we recall that option prices calculated by EEP are more sensitive to the exercise boundary
choice than are prices obtained by FPA (take into account that, under FPA, the option value is
maximal, so small deviations from the optimal boundary must have a negligible effect on the
460 option price). Let us illustrate this point by computing the elasticity of the option price (with
respect to parameter ) under ABEC and EEP (the approximate boundary is given in Equa-
tion (7) with = 1.3). Consider again the American put with S0 = K = 40, = 0.4, r = 0.0488,
and T = 4 months. An increment of 1% in yields a change in the ABEC price of 0.0057%,
whereas the change in the EEP price is 0.021%. This example illustrates how prices obtained
465 by EEP are much more sensitive to the approximate boundary than are prices obtained by
FPA.
We have carried out a sensitivity analysis over a range of alphas (in particular, = 1.2, 1.3,
1.4) for at-the-money, in-the-money, and out-of-the-money options. The quotient of prices
(under ABEC) calculated when = 1.2 and = 1.4 lies in the interval 1 0.0027, which
470 illustrates that option prices are hardly sensitive to the approximate boundary (under EEP, the
interval containing the quotient of prices is much wider). For the three groups of options, the
minimum RMSE (in relative terms) correspond to the case = 1.3 (except for options out of
the money, where the = 1.4 choice gives a slightly better result). The relative RMSEs are as
follows: for out-of-the-money options, 0.14% ( = 1.2), 0.07% ( = 1.3), 0.048% ( = 1.4).
475 For at-the-money options, 0.18% ( = 1.2), 0.06% ( = 1.3), 0.076% ( = 1.4). For in-the-
money options, 0.08% ( = 1.2), 0.05% ( = 1.3), 0.14% ( = 1.4). If we consider absolute
errors (RMSE), = 1.3 gives the best results for the three groups of options (the overall RMSE
is 1.7 103 ). With the = 1.4 choice, the model performs better than if = 1.2 for at-the-
money and out-of-the-money options (but the RMSE considering the 27 options is smaller
480 when = 1.2, 3 103 , than when = 1.4, 4.7 103 ).
It is worth observing that prices are not very sensitive to the functional form of the approx-
imate boundary specification either. If we use the barrier in equation (19) of Bunch and John-
son (2000), the RMSE is 2.5 103 (ABEC) and 3.4 103 (LBBEC). If parameter is
selected to maximize the lower bound, the performance improves from 2.5 103 to 7.8

For the American put with K = , T = years, = ., and r = ., the at-the-money option (S = ) has a price of .
(calculated from a BT with , steps). Our lower bound (method LBBEC, = .) is ., better than that of the lower bound
obtained by LB, .; the price using ABEC is ., which shows that () ABEC does not provide lower bounds and () ABEC
is not necessarily more accurate than LBBEC. If K = , T = months, = ., and r = ., the at-the-money option has a
value of .. The LBBEC price is ., slightly better than the price corresponding to LB. The ABEC price is ..
 14 . GUTIRREZ

104 (ABEC) and from 3.4 103 to 1.3 103 (LBBEC). The performance is better than 485
the (theoretically) exact method of Bunch and Johnson (2000), but extensive computations
are then involved.
A trade-off between accuracy and speed consists of selecting from a set with a small
number of elements (say three or four). The parameter selected will be the maximizer of our
lower bound (LBBEC), which can be used to obtain the ABEC price. We thus obtain extremely 490
accurate prices, avoiding the use of numerical methods involving dozens of iterations. For the
set of options in Table 1, and using the approximate boundary of Equation (7), let us select
from the set {1.2, 1.3, 1.4}. The RMSE of the 27 options is 5.9 104 (0.02% in relative terms)
under ABEC and 1.1 103 (0.03% in relative terms) under LBBEC. Both ABEC and LBBEC
outperform any method in Bunch and Johnson (2000) and in Ju and Zhong (1999), with both 495
papers including extremely accurate methods (much more computationally demanding).
Finally, the first 15 options of table 1 in Ju (1998) have been priced (we take under consider-
ation those 15 with the interest rate above the dividend yield). Again, we use the approximate
boundary of Equation (7) with selected from the set {1.2, 1.3, 1.4}. ABEC performance
is 1.9 103 (RMSE) and 0.038% (relative RMSE), whereas LBBEC performance is 3.6 500
103 (RMSE) and 0.05% (relative RMSE). Jus performance using the three-piece exponential
boundary implementation of EEP is 1.8 103 (RMSE) and 0.037% (relative RMSE). LUBAs
performance is 1.6 103 (RMSE) and 0.017% (relative RMSE).

Summary and conclusions

Modern capital budgeting analysis uses real options techniques in order to account for man- 505
agerial flexibility. A drawback of traditional real options models is the assumption that invest-
ment projects live indefinitely, which represents an unrealistic assumption. Consequently,
simple and accurate pricing methods for American options become valuable.
Many methods have been proposed so far in order to price American option contracts.
Q7 The absence of an analytical solution leads to complex and time-consuming methods if high 510
accuracy is demanded. In this article, a simple pricing methodology capable of fulfilling a
demanding level of accuracy for industrial and academic applications is developed. In a par-
ticular specification (GBM) of a more general method, we offer a closed-form approximation
to the American put price. The method has the desirable feature that numerical solutions of
equations or other iterative procedures are avoided. Its application to more complex contracts 515
(for example, American barrier options) is left for further research.
In terms of accuracy, the method works better than a binomial tree with 150 steps, a method
considered sufficiently accurate for many applications. It also performs better than Barone-
Adesi and Whaley (1987), as well as the improvements proposed by Ju and Zhong (1999), and
can be compared to methods much more computationally demanding. If we ignore meth- 520
ods based on extrapolating approximate option prices (e.g., Carr 1998; Ju 1998) and methods
involving regression coefficients, which are, in turn, calculated from options accurately priced
by other pricing methods (e.g., Broadie and Detemple 1996; Chung et al. 2010), the method
proposed is among the most accurate ones, and no iterative procedures are required (as has
been presented here, the model only contains one free parameter, taken as fixed). For exam- 525
ple, it can compete against Bunch and Johnson (2000, equation (23)), an (in essence) exact
method.
We also provide a very accurate lower bound given in closed form. Its accuracy can be
compared to Ombergs (1987) lower bound with two free parameters. This lower bound can
 THE ENGINEERING ECONOMIST 15

530 be combined with other approximate prices in order to obtain more accurate estimates (if the
lower bound is higher). In addition, if the free parameter is selected among a small number
of sensible choices (say, three), the methods performance can be compared to very efficient
and successful methods (e.g., Ju 1998).
The method is extremely easy to implement, which is appealing if the programming time is
535 valuable. A spreadsheet suffices for practical implementation. We have presented the method
without refinements, but it is easy to improve it in order to attain higher accuracy and speed.
Furthermore, the simple formulation enables one to infer implied volatilities from American
option prices. Finally, it can easily accommodate more sophisticated mathematical specifica-
tions of stock price uncertainty.

Funding
540 The author gratefully acknowledges financial support from the research project ECO2013-48496-C4-
3-R (Ministerio de Economa y Competitividad).

Notes on contributor
scar Gutirrez is Associate Professor of Business Economics at Universidad Autnoma de
Barcelona (Spain). He has a degree in physics and a Ph. D. in economics from Universidad de Zaragoza
(Spain). Among his main research interests are option pricing and managerial incentives. He has pub-
545 lished in the Journal of Economic Dynamics & Control, Journal of Accounting & Economics, and other
journals on finance and economics.

References
Barone-Adesi, G. (2005) The saga of the American put. Journal of Banking & Finance, 29, 29092918.
Barone-Adesi, G. and Whaley, R. (1987) Efficient analytical approximation of American option values.
Journal of Finance, 42, 301320.
550 Berger, P., Ofek, E. and Swary, I. (1996) Investor valuation of the abandonment option. Journal of Finan-
cial Economics, 42, 257287.
Bjerksund, P. and Stensland, G. (1993) Closed-form approximation of American options. Scandinavian
Journal of Management, 9, 8799.
Black, F. and Scholes, M. (1973) The pricing of options and corporate liabilities. Journal of Political
555 Economy, 81, 637654.
Block, S. (2007) Are real options actually used in the real world? The Engineering Economist, 52, 255
267.
Bollen, N. (1999) Real options and product life cycles. Management Science, 45, 670684.
Brennan, M. and Schwartz, E. (1977) The valuation of American put options. Journal of Finance, 32,
560 449462.
Bunch, D. and Johnson, H. (2000) The American put option and its critical stock price. Journal of
Finance, 55, 23332356.
Buonocore, A., Nobile, A.G. and Ricciardi, L.M. (1987) A new integral equation for the evaluation of
first-passage-time probability densities. Advances in Applied Probability, 19, 784800.
565 Carr, P. (1998) Randomization and the American put. Review of Financial Studies, 11, 597626.
Carr, P., Jarrow, R. and Myneni, R. (1992) Alternative characterizations of American put options. Math-
ematical Finance, 2, 87106.
Chen, X., Chadam, J., Jiang, L. and Zheng, W. (2008) Convexity of the exercise boundary of the Amer-
ican put option on a zero dividend asset. Mathematical Finance, 18, 185197.
570 Chen, X., Chadam, J., Jiang, L. and Zheng, W. (2013) Nonconvexity of the optimal exercise boundary
of an American put option on a dividend-paying asset. Mathematical Finance, 23, 169185.
 16 . GUTIRREZ

Chung, S.-L., Hung, M.-W. and Wang, J.-Y. (2010) Tight bounds on American option prices. Journal of
Banking & Finance, 34, 7789.
Cox, J. (1975) Notes on option pricing I: Constant elasticity of variance diffusions. Working Paper,
Stanford University. 575
Q8 Cox, J., Ross, S. and Rubinstein, M. (1979) Option pricing: a simplified approach. Journal of Financial
Economics, 7, 229263.
Daniels, H.E. (1996) Approximating the first crossing-time density for a curved boundary. Bernoulli, 2,
133143.
Davis, G.A. (2002) The impact of volatility on firms holding growth options. The Engineering Economist, 580
47, 213231.
Dixit, A.K. and Pindyck, R.S. (1994) Investment under uncertainty. Princeton University Press, Prince-
ton, NJ.
Durbin, J. (1992) The first-passage density of a Brownian motion to a curved boundary (with an
Appendix by D. Williams). Journal of Applied Probability, 29, 291304. 585
Ekstrm, E. (2004) Convexity of the optimal stopping boundary for the American put option. Journal
of Mathematical Analysis and Applications, 299, 147156.
Geske, R. and Johnson, H. (1984) The American put valued analytically. Journal of Finance, 39, 1511
1524.
Grasselli, M.R. (2011) Getting real with real options: a utilitybased approach for finite-time investment 590
in incomplete markets. Journal of Business Finance & Accounting, 38, 740764.
Gutirrez, O. (2007) Devaluating projects and the investment
uncertainty relationship. Journal of Economic Dynamics & Control,
31, 38813888.
Gutirrez, . (2013) American option valuation using first-passage densities. Quantitative Finance, 13, 595
18311843.
Herath, H.S. and Park, C.S. (2002) Multi-stage capital investment opportunities as compound real
options. The Engineering Economist, 47, 127.
Huang, J., Subrahmanyam, M. and Yu, G.G. (1996) Pricing and hedging American options: a recursive
integration method. Review of Financial Studies, 9, 277300. 600
Jacka, S. (1991) Optimal stopping and the American put. Mathematical Finance, 1, 114.
Jaekel, U. (2005) Pricing of American style options with an adjoint process correction method. Physica
A, 352, 584600.
Johnson, H. (1983) An analytical approximation of the American put price. Journal of Financial and
Quantitative Analysis, 18, 141148. 605
Ju, N. (1998) Pricing an American option by approximating its early exercise boundary as a multipiece
exponential function. Review of Financial Studies, 11, 627646.
Ju, N. and Zhong, R. (1999) An approximate formula for pricing American options. Journal of Deriva-
tives, 7, 3140.
Kanniainen, J. (2009) On the effects of uncertainty on investment timing and option value. The Engi- 610
neering Economist, 54, 175196.
Kim, I.J. (1990) The analytical valuation of American options. Review of Financial Studies, 3, 547572.
Kogut, B. (1991) Joint ventures and the option to expand and acquire. Management Science, 37, 1933.
Li, M. (2008) Approximate inversion of the Black-Scholes formula using rational functions. European
Journal of Operational Research, 185, 743759. 615
Li, M. (2010) Analytical approximations for the critical stock prices of American options: a performance
comparison. Review of Derivatives Research, 13, 7599.
Longstaff, F. and Schwartz, E. (2001) Valuing American options by simulation: a simple least-squares
approach. Review of Financial Studies, 14, 113147.
MacMillan, L.W. (1986) An analytical approximation for the American put price. Advances in Futures 620
and Options Research, 1, 119139.
Majd, S. and Pindyck, R. (1987) Time to build, option value, and investment decisions. Journal of Finan-
cial Economics, 18, 727.
McDonald, R. and Schroder, M. (1998) A parity result for American options. Journal of Computational
Finance, 1, 513. 625
Merton, R. (1973) The theory of rational option pricing. Bell Journal of Economics and Management
Science, 4, 141183.
 THE ENGINEERING ECONOMIST 17

Miller, L.T. and Park, C.S. (2002) Decision making under uncertaintyreal options to the rescue? The
Engineering Economist, 47, 105150.
630 Omberg, E. (1987) The valuation of American puts with exponential exercise policies. Advances in
Futures and Options Research, 2, 117142.
Park, C. and Schuurmann, R. (1976) Evaluations of barrier-crossing probabilities of Wiener paths. Jour-
nal of Applied Probability, 13, 267275.
Park, C.S. and Herath, H. S. (2000) Exploiting uncertaintyinvestment opportunities as real options: A
635 new way of thinking in engineering economics. The Engineering Economist, 45, 136.
Peskir, G. (2002) On integral equations arising in the first-passage problem for Brownian motion. Jour-
nal of Integral Equations and Its Applications, 14, 397423.
Ricciardi, L., Sacerdote, L. and Sato, S. (1984) On an integral equation for first-passage-time probability
densities. Journal of Applied Probability, 21, 302314.
640 Roberts, G.O. and Shortland, C.F. (1995) The hazard rate tangent approximation for boundary hitting
times. The Annals of Applied Probability, 5, 446460.
Sarkar, S. (2000) On the investmentuncertainty relationship in a real options model. Journal of Eco-
nomic Dynamics & Control, 24, 219225.
Trigeorgis, L. (2005) Making use of real options simple: an overview and applications in flexi-
645 ble/modular decision making. The Engineering Economist, 50, 2553.
Van Moerbeke, P. (1976) On optimal stopping and free boundary problems. Archive for Rational
Mechanics and Analysis, 60, 101148.
Wong, K.P. (2007) The effect of uncertainty on investment timing in a real options model. Journal of
Economic Dynamics & Control, 31, 21522167.
650 Zambujal-Oliveira, J. and Duque, J. (2011) Operational asset replacement strategy: a real options
approach. European Journal of Operational Research, 210, 318325.