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Gad, Kamille Sofie Tågholt
Pedersen, Jesper Lund
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[Journal:] Risks [ISSN:] 2227-9091 [Volume:] 3 [Year:] 2015 [Issue:] 2 [Pages:] 103-111
In this paper, irrational exercise behavior of the buyer of an American put is characterized by a single parameter. We model irrational exercise rules as the first jump time of a point processes with stochastic intensity. By the rationality parameter, we parameterize a family of stochastic intensities that depends on the value of the put itself. We present a probabilistic proof that the value of the American put using the irrational exercise rule converges to the arbitrage-free price as the rationality parameter converges to infinity. Another application of this result is the penalty method for approximating the price of an American put.
behavioral modeling
irrational exercise rule
partial differential equation
penalty method
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