A Simulation Based Optimization Model for Pricing Basket Options

Subject Areas : Financial engineering

Ehsan Hajizadeh ¹ , Masoud Mahootchi ²

1 - Ph.D, Industrial Engineering and Management Systems Department, Amirkabir University of Technology, Tehran, Iran
2 - Associate Professor., Industrial Engineering and Management Systems Department, Amirkabir University of Technology, Tehran, Iran

Received: 2018-06-23 Accepted : 2018-10-01 Published : 2019-03-21

Keywords: Simulation, Pricing, Approximate Dynamic Programming, Basket Options,

Abstract :

Today, in the famous financial markets, options and futures are very important contracts for reducing the risk of investors. Many active practitioners in the financial markets really believe that mispricing or incorrect valuation of these securities would be the main reason of collapse of some financial institutions. The complexity of option pricing/valuation, especially in the case of American basket options, as high dimensional options, has motivated many researchers to develop numerical and simulation-based models. In this paper, a new simulation-based approach for pricing/valuation of American basket option is proposed. Furthermore, for scenarios generation, we use a Monte Carlo simulation technique using a t-student copula-GARCH method and Extreme Value Theory to handle the nonlinearity of dependencies between variables. To verify the computational efficiency and the accuracy of the proposed methodology, we compare the results of prices obtained through the proposed models with those achieved through the Monte Carlo simulation and the method developed by Ju for European basket options.