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ABSTRACT
Using martingale methods, we find that the expected optimal exercise time of a perpetual, dividend-paying American call option contract is the ratio of the time-independent stopping boundary to the risk-adjusted drift of the stock price process. This ratio is an analytical expression. Of independent interest is the computational simplicity of our derivation. Specifically, we use only the optional sampling theorem of martingale theory and elementary algebra. In contrast, the non-martingale approach requires tedious integration and solution of an ordinary differential equation. Key Words and Phrases: Brownian motion, first passage time, martingale, American call option, optimal exercise.
Rudy Yaksick; Graduate School of Management, Clark University, 950 Main Street; Worcester, Massachusetts 01610. Rudy Yaksick is also a Lecturer in the Department of Finance and Economics, Boston University and Research Associate, Center for the Study of Financial Engineering. The author is particularly indebted to Professors I. Karatzas and M. Tamarkin for advice and encouragement as well as to E. Henning for technical comments. Finally, this research was partially supported by the Institute for Mathematics and its ApplicationsUniversity of Minnesota, with funds provided by the U.S. National Science Foundation.
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I. INTRODUCTION
Martingale methods simplify the solution of stochastic, sequential decision problems. For example, Chung (1974, pp. 327-28) uses martingale methods to demonstrate in two lines, and "without any computation" (his quotes), that the probability of a gambler's ruin is inversely proportional to the gambler's initial capital. This note has a similar objective. That is, we aim to demonstrate that martingale methods greatly simplify the solution of two problems. The first is the classic problem: What is the expected first passage (stopping) time to a single, fixed boundary of a Brownian motion with drift? The first passage time is of interest since the solution of a wide variety of gambling and investment decision problems often involves determining whether and when a key, underlying stochastic process hits some boundary. For example, in the classic gambler's ruin problem one of the main issues is: What is the expected duration of the game? This issue can be rephrased in sharper, analytic terms as: How much time will elapse, on average, before the gambler's discounted net gain reaches a boundary level of zero? In Section II we demonstrate the relative ease with which one can derivevia martingale methodsthe Laplace transform of the first passage time (to a single boundary) density function of a Brownian motion with drift. The derivation begins with a straightforward application of the optional sampling theorem to martingales associated with Brownian motion. Then, elementary algebra is used to obtain the transform. This is a much less tedious approach than the common practice (as illustrated in Srinivasan and Mehata [1978] section 5.5) of computing the Laplace transforms of the terms of the backward Kolmogorov equation and then solving the resultant linear ordinary differential equation in order to obtain the Laplace transform of the first passage density function. Having obtained the Laplace transform, we simply differentiate it to obtain our main probabilistic result. The expected first passage time is the ratio of the stopping boundary to the drift of the Brownian motion. The second problem (which is addressed in Section III) is of particular interest to finance practitioners in both the investment and corporate sectors. Hedging, speculation, arbitrage, and capital budgeting decisions often hinge on the issue: What is the expected optimal exercise (stopping) time of an American option contract that pays dividends? An American option is a financial security which gives the holder the right, but not the obligation, to exercise the option (and thereby obtain the underlying asset of the option) at any time throughout the life of the option. We preface the analysis of this issue by reviewing McKean's (1965) seminal analysis of the pricing of a perpetual American warranta security closely related to an American option. Then, we replicate his analysis
within the context of Karatzas' (1988, 1989) recent martingale-based framework for valuing American options. In this framesvork, which is a bit more elaborate than the Harrison-Pliska (1981) seminal model, the key economic idea of the absence of arbitrage opportunities is linked to the probabilistic concept of a martingale. Moreover, this framework is quite general since it enables market participants to consume as well as invest, thus permitting a unified approach to the problems of option pricing, consumption and investment, and equilibrium in a financial market. Our main financial result is that (for a perpetual, dividend-paying American call option) the optimal exercise time is the ratio of the stopping boundary (b) to the drift of the transformed stock price process. Here, b equals the product of the inverse of the stock volatility times the log of the ratio of the optimal exercise stock price to the initial (time zero) stock price. And the optimal exercise stock price is a function of the risk-free rate and the drift and volatility parameters of the stock price stochastic process. Thus, the optimal exercise time is easily computable since it is an analytical expression. We conclude (in Section IV) by suggesting future research tasks that may confirm the computational simplicity of martingale methods under a wider class of stochastic processes as well as stopping problems having more general, curved and time-dependent boundaries. Finally, all proofs are contained in Appendix A.
Brownian Motion Let: i) (O,F,P) be a filtered probability space; ii) B = (B(t), F,; 0 < t < ) be a continuous stochastic process on this space; and, iii) u and o denote the drift and dispersion coefficient parameters of B, respectively. We say that B is a one-dimensional (u, a) Brownian motion with respect to F if: i) B is adapted to the filtration F = (F c , tTc[0,]), where T is the continuous time index set, of the measurable sample space (Q,F). ii) B(t) = B(0) + ut + oW(t), t > 0, where W is a standard Brownian motion (Wiener process) and B(0) is independent of W. iii) For 0 S s < t, every increment B(t + s) - B(s) is independent of Fs and is normally distributed with constant mean ut and constant variance crt. iv) B(0) = 0, a.s.
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First Passage Time Suppose that i) (fl.F) is a measurable sample space with a filtration F, and ii) (den is a sample point in the outcome space 2. We say that the random variable Tb, where Tb: fl - T, is a first passage time (with respect to F) to a single boundary beR if, for every ter
Lemma 2.3: Let V(t), the martingale defined in (2.1), satisfy the hypotheses of Lemma 2.2; let Tb be a stopping time. Suppose that the hypotheses of the optional sampling theorem are satisfied. Then: l=E[V(T b At)]
(2.3)
(
Lemma 2.1:
infft S 0; B (co) = b], if B (co) S b and sign u = sign b, for some t S 0 oo, if Bt(co) < b and sign u = sign b, for all 1 2 0
where (TbA t) = min(Tb, t). Lemma 2.4: Let V(t), the martingale defined in (2.1), satisfy the hypotheses of Lemma 2.2; let Tb be a stopping time. Suppose that the hypotheses of the optional sampling theorem are satisfied. If i) A, is sufficiently large such that 0 > 0 and, thus, 0 < V(Tb A t) < exp (Xb); and, ii) the collection of random variables {V(Tb A t ) } is uniformly integrable, i.e., lim<wpE[IV<TkAt)ll,V(TiAl)>e,]) = 0
Then:
(2.4)
Let I3(t) be the Brownian motion process defined earlier. Associated with B(t) is the following martingale: V(t) = exp[XB(t) - 0t] where 0 s Xu + XV/2, and \ is any arbitrary, real constant. Lemma 2.2: Optional Sampling Theorem Let V(t) be the martingale defined in (2.1); let Tb be a stopping time. If i) Prob (Tb < 00} = i, ii) BtfV<Tj|| < . and iii) as n - . lim E[V(n)l (T|>> .,] = 0, where l(T b >ni ' s an indicator function having a value 1, when Tb > n, and zero, otherwise. Then: E[V(0)]
(2.2) (2.1)
With these intermediate results, we now obtain our first main probabilistic result. Theorem 2.1: Laplace Transform of First Passage Time Density Suppose that i) B(t) is a (u,o) Brownian motion; ii) b#Q is the single, fixed boundary; and iii) Tb is the first time, if any, that B(t) reaches the level b. Then the Laplace transform of the first passage time density of B(t) to a single boundary b is: E^le-^J = exp(ub/o2 - |b|[(u2 + 2d2Q)i]l<?}, 0 > 0 (2.5) *>
The second main result identifies the relationship between the drift and boundary that must be satisfied for Tb to have a finite value with probability one.
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Theorem 2.2: Existence of Finite First Passage Time Retain the hypotheses of Theorem 2.1. Then B(t) attains b * 0 with probability one if and only if u and b have the same sign. Our final resultthe expected first passage time of a Brownian motion process with driftis obtained by differentiating (2.5), the Laplace transform of the first passage time density function of B(t) to a single boundary. Theorem 2.3: Expected First Passage Time Retain the hypotheses of Theorem 2.1. Then, the expected first passage time of B(t) is:
b/u, , Intuition
(2.6)
The underlying intuition of the result is clearly illustrated in Figure 1. The process B(t) increases deterministically along the straight trend line with slope u. Thus, u measures the expected rate of change in B, per unit time. That is, u = (E[B(t)] - B(t0))/t. The height of the time-independent boundary (line bb) indicates the vertical distancein this case b unitsthat B(t) must travel in order to reach the boundary. Since B(t) is expected to change (increase) in value by u units per unit time, the expected time to traverse the height of b units (i.e., reach the boundary) is thus b/u. Of course, the actual time to first passage to the boundary could be greater or less than E[TJ since B(t) will fluctuate around the trend line due to the random shocks odW. As a further aid to understanding, the main result can be interpreted in the context of a gambling problem. In that problem, our result indicates that the expected duration of the gambler's game is the ratio of the gambler's initial wealth to the drift of the net gain process. Finally, to gauge the computational simplicity of the martingale approach to computing the expected duration of a gambling game, the reader is directed to Feller (1968, pp. 348-49). In a random walk setting, he employs the more tedious method involving the solution of difference equations.
TIME
[T
b]
where r > 0 is a constant, continuously compounded interest rate offered to all borrowers and lenders. The underlying asset, on which the perpetual American call option is written, is a stock whose price S(t) satisfies the linear, stochastic differential equation:
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(3.2)
where m(t) is the "drift" or instantaneous expected growth rate of S(t); ue(0,r), the dividend rate, and a are non-negative constants; and dW(t) is a Standard Brownian motion under P. Finally, the third asset is a perpetual American call option with an exercise price, q = $1.
I,,' = inf{t > 0; W0(t) + vt 5 B} where the exercise boundary (B) is: B = (l/o)log[SVS(0)]
(3.6)
Results
In this context McKean obtained a closed-form solution for the two unknowns of the warrant holder's valuation (optimal stopping) problem. These are the optimal exercise time (T'B) and the time-independent exercise (stopping) boundary (S'), respectively: i) T'B = inf{t > 0; S(t) S S*} for all tE[0,] ii) S' = $/(<*> - 1) > 1 where: O a [(52 + 2ro2)5 - Sj/o2 and S s r - u -.So2
(3.7)
and:
i) S* = q[<D/(<I> - 1)]E(0,~) ii) O = (o2)-'[(82 + Iro2)5 - 8], 1 < <D< r (r - u)-1
in) 8 = r - u - .So2 iv) v = 8/a
(3.3) (3.4)
(3.5)
Lemma 3.2: The Laplace transform of TB is: E[exP(-aT,j)] = exp{[Bv - |B| (v2 + 2o2a)5]/cr), a > 0 (3.8)
The third lemma specifies the relationship that must hold between the parameters B and v (as well as the sign of v) for the exercise time to be
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finite-valued with probability one. Thus, this lemma is the analogue of Theorem 2.2. Lemma 3.3: Suppose that S* > S(0), and v, B * 0. Then, S(t) reaches S* (equivalently, W0(t) + vt attains B) with probability one if and only if v and B have the same sign. Finally, we obtain our main financial result. Theorem 3.1: Expected Optimal Exercise Time. Retain the hypotheses of Lemma 3.3. Then, the expected optimal exercise time of a perpetual American call option that pays continuous dividends is:
E(V)[TJ =
P/v,
[-,
ifpandv>0
if p > 0, v < 0
(3.9)
In sum, this appears to be a novel result. The closest work to this appears to be Carman's (1989) concept of "fugit" (an abbreviation of the Latin phrase tempus fugit, or "time flies"). This concept measures the average lifetime of an American option. However, this concept was developed in a discrete-time setting. Thus, it yields only an approximate measure of the expected optimal exercise time.
transmission lines. Martzoukos and Teplitz-Sembitzky used martingale results (similar to those used here) to compute the expected optimal timing of this irreversible, expensive investment in transmission lines, given uncertainty about demand.-Another cogent example is Collins' (1992) use of the first passage density to estimate the expected timing of foreign exchange realignments in the European Monetary System. Finally, our result is easy to implement, relative to the finite-lived option case which requires numerical methods, because the optimal exercise boundary can be found by analytic means. That is, using the classical optimization methods employed by McKean, one can find the optimal exercise boundary by simply maximizing the optimal value of the option over the set of boundary points (since the "boundary" in this case is a single point), e.g., Karlin and Taylor (1975, pp. 364-65). Alternatively, one can take a more elegant analytical approach, such as the one developed by Karatzas (1989, sec. 6). He applied martingale methods to the option buyer's optimal exercise (stopping) problem in order to prove the existence of an optimal stopping time as well as characterize it in terms of an optimal exercise boundary that is identical to that first computed by McKean.' Several extensions to this research might aid in confirming the computational simplicity obtainable via martingale methods. First, the class of stopping problems might be widened to include curved and time-dependent boundaries. This would, in turn, permit the comparison of the simplicity of the martingale approach against, for example, the complexity of: 1) Durbin's (1985) approximation of the first passage time (FPT) density of a continuous Gaussian process to a general boundary, and 2) Durbin and Williams' (1992) recent approximation of the FPT density of a Brownian motion to a curved boundary. Their approximation is a convergent series of multiple integrals of increasing dimensionality. Of course, these densities would subsequently be integrated in order to compute the moments. Likewise, the mean (and higher moments) for processes other than Brownian motion with drift should also be computed via martingale methods. Then a basis would exist for comparing the computational effort of this work against the results of Ricciardi and Sato (1988). They have derived closed-form expressions for all moments of the first passage time of the unrestricted, conditional OrnsteinUhlenbeck process with a constant boundary.
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APPENDIX
A.I Section II Proofs We begin by proving four lemmas that are intermediate results required for the proof of Theorem 2.1. PROOF: Lemma 2.1. The objective of the proof is to demonstrate, via simple computation, that exp(XB(t)) satisfies the martingale property. First, the Markov property- implies that: E[exp(XB(t)IF,)] = exp(XB(s)) E[exp(X(B(t) - B(s)))IFJ = exp(XB(s)) exp{(Xut + XVt/2) - (Xps + XVs/2)} = exp(XB(s)) expHXus + XVs/2)} x exp{(Xfit + X:cri/2)}
CA.l)
(A.5)
PROOF: Lemma 2.4. Passing to the limit as t- >, we observe from the conclusion of Lemma 2.3, that: 1 =limE[V(T b A t ) ]
|_tM
(A.6)
= E[lim V(Tb A t)] where the limit can be taken under the expectation operator since (V(Tb At)} is hypothesized to be uniformly integrable and, thus, Theorem 5 of Shiryayev (1984, p. 187) can be invoked. Also: fexp{Xb - 0Tb). HmV(Tb A t) = ' |0, if Tb ifT k
(A.7)
since E[exp(XB(t))] = exp(Xut + XVt/2) because B(t) - B(s) Is independent of F, and is distributed N(u(t - s), (^(t - s)). PROOF: Lemma 2.2. Optional Sampling Theorem. See Karatzas and Shreve (1991, p. 19). PROOF: Lemma 2.3. First, we know that E[V(T b At)]=E[V(T b )] (A.2)
since V(Tb A t) = V(T,,) whenever Tb < ~ and t > Tb. Since Tb is finite-valued by hypothesis, we can use (A.7) to re-xpress (A.6) as: 1 = E[exp(Xb - 0Tb)] 1 = e^texpt-eT,,)], or E[e-6T"] = e-u
(A.8)
where T,,At = min{Tb,t}, since V[(Tb A t)] = V(TJ whenever Tb < Mid t > Tb. Next, by Lemma 1 and B(0) = 0, we know that: E[V(0)] = E[exp(XB(0) - 90)] = Etexp(O)], so E[V(0)] = 1 Also, by Lemma 2.2, we know that: E[V(0)] = EtVOUl (A.4) (A.3)
PROOF: Theorem 2.1. By Lemma 2.1 we know that V(t) is the martingale associated with B(t), i.e. V(t) = exp{XB(t) - t)
(A.9)
where 8 - Xu + XV/2, and X is any teal constant. By Ummas 2 and 3 we conclude that 1 = E<"[V(Tb A t)]. Using (A.9), we show:
1=
A t ) - 0(Tb A t)}]
(A.10)
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Passing to the limit as t-+ oo, and using Lemma 2.4, we can conclude that:
1 = lim
PROOF: Theorem 2.2. Following Karlin and Taylor (1975, p. 362), we know that:
(A. 19)
8->U
jf5exP^B<Tb
1=
0 - 0(Tb At)}],
(A. 11)
*U or
-\t = e-
(A.12)
Using (A. 18), we obtain: P w [T k < oo] = Hm exp([bu - Ibl (u2 + 2o20)3]/crz}, 0 > 0 (A.20) e->o After evaluating the limit, we conclude that:
The final step is to obtain a relationship between 6 and % that satisfies the constraint:
<; 1
(A. 13)
(A.21)
(A. 14)
Given the initial definition of 0, we know that: l/2o*X2 + \ik - 0 = 0 Applying the quadratic formula, we conclude that: (A.15)
Hence:
1, ub > 0
pW[ T <
< 1, ub < 0
(A.22)
u - (u2 + 2o2) 5]/o2, b < 0 Substituting (A. 16) into the right-hand side of (A.12), we find that the af*/* transform ! Laplace fi*anefXfr is:
Thus, whenever p and b have different signs, the density of Tb under P*M) is defective since Tb is infinite with positive probability. That is: p(f)[T b = oo] = 1 - exp((bu >0
(A.23)
In conclusion, Tb is not finite-valued if we suppose that b and u have different signs. PROOF: Theorem 2.3. Differentiating (A. 18) wi side by -1, we obtain: multiplying each
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Our second major conclusion is: + 2a20)5]}exp(ub/a2 - |b|[(u2 + 2c20)5]/o2) (A.24) Finally, evaluating the derivative as 010, we obtain our main result: E*[TJ = b/u (A.25)
1, < 1, > 0 and v > 0 < 0 and v > 0
(A.31)
Thus, whenever v and B have different signs, the density of TB under P<v) is defective since T, is infinite with positive probability. That is: p("[T8 = H = 1 - exp{(Bv -
>0
(A.32)
In conclusion, T6 is not finite-valued if we suppose either that B and v have different signs or v < 0. Note, for a slightly different starting point in the proof, the reader is urged to consult Karatzas and Shreve (1991, pp. 196-97). PROOF: Theorem 3.1. Differentiating the Laplace transform with respect to a, and multiplying each side by -1, we obtain: E[TB] = B(v2 + 2o2a)-5E[exp(-<xTB)] Letting aio, we obtain E[TB] = B/v, where B,v > 0. (A.33)
since T?* is, by definition, the first time that the P0-Brownian motion W0(t) + v, with drift [(r - u)/o] - .5<T, hits or exceeds the level B = log(S'/S(0))/o. Hence, EJexp(-rTp')] = 1 for S(0) S'. PROOF: Lemma 3.2. Following the argument of the proof of Theorem 2.1, one can easily demonstrate that the Laplace transform of T, is: = exp([Bv - jBKv 2 + 2cr!a)5]/(r) a > 0 (A.28)
NOTE
1. See Myneni (1992) for an illustration of this approach, when applied to the valuation of a finite-lived American put option. Unfortunately, this approach does not lead to an explicit solution for the optimal exercise boundary. Instead, one has to first reformulate the optimal stopping problem as a free boundary problem. Then, the optimal exercise boundary <::m be found (via numerical methods) as the solution of n nonlinear integnii . ' ..terra) equation. Finally, to understand the link between optimal stopping and free boundary problems, the reader is urged to consult the seminal references: Mikhalevich (1958), Chemoff (1961), and Lindley (1961).
PROOF: Lemma 3.3. Following the argument of Theorem 2.2, one can easily demonstrate that: P*V)[T6 < oo] = exp{(Bv - I Our first conclusion is straightforward. If v < 0, then:
P[T, = ] = 1 - P(TB < oo) > 0
(A.29)
(A.30)
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REFERENCES
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McKean, H., "Appendix: A Free Boundary Problem for the Heat Equation Arising from a Problem in Mathematical Economics," Industrial Management Review, 6, 1965, pp. 32-39. Mikhalevich, S., "A Bayes Test of Two Hypotheses Concerning the Mean of a Normal Process," Visnick Kiius'kogo University, 1, 1958, pp. 101-104. Myneni, R., "The Pricing of the American Option," The Annals of Applied Probability, 2, 1992, pp. 1-23. Ricciardi, L. M. and S. Sato, "First-Passage-Time Density and Moments of the Ornstein-Uhlenbeck Process," Journal of Applied Probability, 25,1988, pp. 43-57. Shiryayev, A. N., Probability, New York: Springer-Verlag, 1984. Srinivasan, S. K. and K. M. Mehata, Stochastic Processes, New York: McGraw-Hill, 1978.
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