Valuing American Options in a Path Simulation Model

Abstract

The goal of this paper is to dispel the prevailing belief that American-style options cannot be valued efficiently in a simulation model, and thus remove what has been considered a major impediment to the use of simulation models for valuing financial instruments. We present a general algorithm for estimating the value of American options on an underlying instrument or index for which the arbitrage-free probability distribution of paths through time can be simulated. The general algo-rithm is tested by an example for which the exact option premium can be determined. 1.