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Title of Thesis

American Foreign Exchange Put Option Problem

Author(s)

NASIR REHMAN

Institute/University/Department Details
Abdus Salam School of Mathematical Sciences / GC University, Lahore
Session
2009
Subject
Mathematics
Number of Pages
79
Keywords (Extracted from title, table of contents and abstract of thesis)
American, Foreign, Exchange, Option, Problem, currency, monotonicity, volatility, strikes, maturities

Abstract
The classical Garman-Kohlhagen model for the currency exchange assumes that the domestic and foreign currency risk-free interest rates are constant and the exchange rate follows a log-normal diffusion process.
In this thesis we consider the general case, when exchange rate evolves according to arbitrary one-dimensional di usion process with local volatility that is the function of time and the current exchange rate and where the domestic and foreign currency risk-free interest rates may be arbitrary continuous functions of time. First non-trivial problem we encounter in time-dependent case is the continuity in time argument of the value function of the American put option and the regularity properties of the optimal exercise boundary. We establish these properties based on systematic use of the monotonicity in volatility for the value functions of the American as well as European options with convex payoffs together with the Dynamic Programming Principle and we obtain certain type of comparison result for the value functions and corresponding exercise boundaries for the American puts with different strikes, maturities and volatilities.
Starting from the latter regularity property that the optimal exercise boundary curve is left continuous with right-hand limits we give a mathematically rigorous and transparent derivation of the significant early exercise premium representation for the value function of the American foreign exchange put option as the sum of the European put option value function and the early exercise premium.
The proof essentially relies on the particular property of the stochastic integral with respect to arbitrary continuous semimartingale over the predictable subsets of its zeros. We derive from the latter the nonlinear integral equation for the optimal exercise boundary which can be studied by numerical methods.
We establish several continuity estimates for the American option value process, the optimal hedging portfolio and the corresponding consumption process with respect to volatility function. For these estimates the volatility is assumed to be arbitrary strictly positive bounded function of time.

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S. No. Chapter Title of the Chapters Page Size (KB)
1 0 CONTENTS

 

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2

1

PRELIMINARIES

1.1 Exchange rate process

1.2 The value process and the value function of American put option
1.3 The Continuation Set

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3 2 CONTINUITY OF THE AMERICAN FOREIGN EXCHANGE PUT VALUE FUNCTION

2.1 The Continuity Proposition

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4 3 THE REGULARITY PROPERTIES OF THE OPTIMAL EXERCISE BOUNDARY

3.1 Semimartingale representation of the discounted payoff process

3.2 Upper bound for the optimal exercise boundary
3.3 Two auxiliary inequalities
3.4 Comparison of the American put values with di erent strikes, maturities and volatilities
3.5 Left continuity of the boundary and existence of right-hand limits

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5 4 EARLY EXERCISE PREMIUM REPRESENTATION

4.1 Main Theorem

4.2 Nonlinear integral equation for the optimal exercise boundary

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6 5 CONTINUITY ESTIMATES WITH RESPECT TO VOLATILITY

5.1 Introduction

5.2 The Lipschitz property of the American put value process with respect to volatility
5.3 Continuity estimates for the optimal hedging portfolio and the related consumption process

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7 6 BIBLIOGRAPHY

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