Optimal Stopping and the American Put

Abstract

We show that the problem of pricing the American put is equivalent to solving an optimal stopping problem. the optimal stopping problem gives rise to a parabolic free‐boundary problem. We show there is a unique solution to this problem which has a lower boundary. We identify an integral equation solved by the boundary and show that it is the unique solution to this equation satisfying certain natural additional conditions. the proofs also give a natural decomposition of the price of the American option as the sum of the price of the European option and an “American premium.”