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MAYbe
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Joined: July 8th, 2016, 2:37 pm

First passage probability in american put option pricing

April 2nd, 2017, 6:55 pm

In an article i recently read (The American Put Option and Its Critical Stock Price by David S. Bunch and Herb Johnson) the authors presented this formula as something very general and as common knowledge

$$P = \mathop {\max }\limits_{{S_c}} \int\limits_0^T {{e^{ - rt}}(X - S_c)} fdt,\quad (S > {S_C})$$ 


where P, r, T, X, and Sc are the American put price, risk-free rate,
time to maturity, exercise price, and critical stock price,
respectively.Let S be the current stock price (at time  t= 0).f,
is the first-passage probability,

However i cant recall that i have seen this formula AND f in the same formula, what am I missing? Where did this formula come from? How would one go about if one needs to derive this formula? Is there a similar formula ?
Last edited by MAYbe on April 6th, 2017, 8:47 am, edited 1 time in total.
 
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Alan
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Re: First passage probability in american put option pricing

April 3rd, 2017, 8:57 pm

I haven't read that paper in a while and I don't see an online accessible link. But I strongly suspect it is supposed to be some kind of approximation. It doesn't look correct if meant to be exact. For example, letting r -> 0, P should tend to the euro-style value. But since Sc->0 for t < T, f would also tend to 0 for t<T and that formula would say P->0, not P -> P_euro. 
 
MAYbe
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Joined: July 8th, 2016, 2:37 pm

Re: First passage probability in american put option pricing

April 3rd, 2017, 9:18 pm

this is how it is presented in the article,
 
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travisf
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Re: First passage probability in american put option pricing

April 4th, 2017, 12:57 pm

Maybe: maybe you are thinking $S_c$ is a number?  It is a curve. From that paper, "The maximization is taken over all possible functions $S_c(\tau)$, where $\tau \equiv T-t$."  For the limit Alan is testing, the curve $S_c(\tau)$ is approximately zero for $\tau > 0$ but goes to the strike at expiry.  That curve is hit at expiry or not at all, giving exercise at expiry if the option is in the money, i.e. the European option limit.
 
MAYbe
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Posts: 30
Joined: July 8th, 2016, 2:37 pm

Re: First passage probability in american put option pricing

April 5th, 2017, 3:38 pm

Maybe: maybe you are thinking $S_c$ is a number?  It is a curve. From that paper, "The maximization is taken over all possible functions $S_c(\tau)$, where $\tau \equiv T-t$."  For the limit Alan is testing, the curve $S_c(\tau)$ is approximately zero for $\tau > 0$ but goes to the strike at expiry.  That curve is hit at expiry or not at all, giving exercise at expiry if the option is in the money, i.e. the European option limit.
Actually, I knew that before , I was after where it came from, like origin since i have not seen this with $f$ included anywhere else .