Pricing American Options Using Monte Carlo Simulation

This paper modifies Barraquand and Martineau (BM, 1995) and Raymar and Zwecher (RZ, 1997) models to value American options using Monte Carlo simulation. The contribution of this article is threefold. First, we point out that the holding values in the BM and RZ models are biased. We then propose a correction model and show that the point estimate, low estimate, and high estimate of American option values calculated from our model are more accurate than those obtained from the BM and RZ models. Second, we investigate how the bucket formation method and the number of buckets will affect the accuracy and convergence of price estimates. Third, we show that our model is appropriate for valuing many American-style options such as barrier, lookback, and Asian options etc.. Key words: Monte Carlo simulation, option valuation, American option, holding value