Perpetual American Standard and Lookback Options in Insider Models with Progressively Enlarged Filtrations

TL;DR

This paper derives explicit solutions for optimal stopping problems related to pricing perpetual American options in insider models with enlarged filtrations, involving complex stochastic boundaries and free-boundary problems.

Contribution

It introduces a novel approach to solve perpetual American options in insider models with progressively enlarged filtrations, providing explicit boundary characterizations.

Findings

Closed-form solutions for optimal stopping boundaries.

Characterization of exercise times via stochastic boundaries.

Application of free-boundary problem techniques.

Abstract

We derive closed-form solutions to the optimal stopping problems related to the pricing of perpetual American standard and lookback put and call options in the extensions of the Black-Merton-Scholes model with progressively enlarged filtrations. More specifically, the information available to the insider is modelled by Brownian filtrations progressively enlarged with the times of either the global maximum or minimum of the underlying risky asset price over the infinite time interval, which is not a stopping time in the filtration generated by the underlying risky asset. We show that the optimal exercise times are the first times at which the asset price process reaches either lower or upper stochastic boundaries depending on the current values of its running maximum or minimum given the occurrence of times of either the global maximum or minimum, respectively. The proof is based on the reduction of the original problems into the necessarily three-dimensional optimal stopping problems and the equivalent free-boundary problems. We apply either the normal-reflection or the normal-entrance conditions as well as the smooth-fit conditions for the value functions to characterise the candidate boundaries as either the maximal or minimal solutions to the associated first-order nonlinear ordinary differential equations and the transcendental arithmetic equations, respectively.