The stopping time in layman’s terms…

Stopping time is a concept related to stochastic processes in mathematics and statistics. In the context of exotic option pricing, stopping time can refer to the decision-making process about when to exercise the option before its expiration, under conditions that optimize the payoff.

Exotic options have complex features and terms. They might include different types of payoffs or be activated or deactivated under certain conditions or specific events.

Models like Black-Scholes-Merton, which are often used for pricing standard options, are sometimes not sufficient for exotic options. Alternative models, such as Binomial Tree models, Monte Carlo simulations, and Finite Difference methods, are used to estimate their value. Each exotic option has unique characteristics, and the models need to be adapted accordingly, sometimes involving the concept of stopping time to optimize the option's exercise strategy to maximize its value.

The pricing of an American option can be approached using a Binomial Tree model. The option's price is computed backward from expiry, and at each node, we compute the option's value based on the maximum of either exercising the option immediately or holding it for future exercise.

The Immediate Exercise Value for a call option is calculated as the max of 0 and (S - K), and for a put option, it’s the max of 0 and (K - S), where S is the stock price, and K is the strike price.

The Hold Value is derived from the expected future value of the option, discounted back at the risk-free rate. This takes into account the risk neutral probabilities (*) of the stock’s price moving up or down.

Consider a simple 1-period binomial model. The current stock price is $50. It can either go up to $60 or down to $40 in one period with equal probability. We want to price an American call option with a strike price of $50.

1. At expiry, the immediate exercise values would be:
• $10 if the stock price rises to $60 (max of 0 and $60 - $50).
• $0 if the stock price falls to $40 (max of 0 and $40 - $50).
2. The hold value at each node is the expected future option value, discounted at a 5% risk-free rate, considering equal probabilities of price movements:
• The hold value is (0.5*$10 + 0.5*$0) / (1+0.05) = $4.76.
3. We then compare the immediate exercise value and hold value:
• With a $50 stock price, immediate exercise yields $0 (max of 0 and $50 - $50).
• The hold value is $4.76.

So, the option’s holder is better off holding the option rather than exercising it immediately, and the option's price at $50 stock price is $4.76.

The stopping time problem here involves determining at which point (if any) before expiry the option holder should exercise the option to maximize their payoff.

(*)Risk-neutral probability is a theoretical probability measure that adjusts the actual probabilities of different outcomes to account for the risk-free rate of return.

#StoppingTime #ExoticOptions #AmericanOption