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Game Call Options Revisited

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Mathematical Finance

Published online on

Abstract

In this paper, having been inspired by the work of Kunita and Seko, we study the pricing of δ‐penalty game call options on a stock with a dividend payment. For the perpetual case, our result reveals that the optimal stopping region for the option seller depends crucially on the dividend rate d. More precisely, we show that when the penalty δ is small, there are two critical dividends 0 < d1 < d2 < ∞ such that the optimal stopping region for the option seller takes one of the following forms: (1) an interval if d < d1; (2) a singleton if d∈ [d1, d2]; or (3) an empty set if d > d2. When d∈ [d1, d2], the value function is not continuously differentiable at the optimal stopping boundary for the option seller, therefore our result in the perpetual case cannot be established by the free boundary approach with smooth‐fit conditions imposed on both free boundaries. For the finite time horizon case, the dependence of the optimal stopping region for the option seller on the time to maturity is exhibited; more precisely, when both δ and d are small, we show that there are two critical times 0 < T1 < T2 < T, such that the optimal stopping region for the option seller takes one of the following forms: (1) an interval if t < T1; (2) a singleton if t∈ [T1, T2]; or (3) an empty set if t > T2. In summary, for both the perpetual and the finite horizon cases, we characterize in terms of model parameters how the optimal stopping region for the option seller shrinks when the dividend rate d increases and the time to maturity decreases; these results complete the original work of Emmerling for the perpetual case and Kunita and Seko for the finite maturity case. In addition, for the finite time horizon case, we also extend the probabilistic method for the establishment of existence and regularity results of the classical American option pricing problem to the game option setting. Finally, we characterize the pair of optimal stopping boundaries for both the seller and the buyer as the unique pair of solutions to a couple of integral equations and provide numerical illustrations.