English

Valuing American options and Flexible Forwards contracts in time-dependent models

Computational Finance 2026-06-25 v1 Numerical Analysis Mathematical Finance Pricing of Securities

Abstract

A flexible forward (FF) is a customized FX hedging instrument that guarantees a fixed exchange rate while letting the holder choose the delivery date within a pre-agreed window. It is therefore an American-style option on timing, and its valuation must respect the volatility skew of the underlying currency pair. We price FF contracts (and, more generally, American options) under a time-inhomogeneous Heston model which captures the forward-skew term structure while preserving analytical tractability through a recursive (matrix) Riccati solution for the joint characteristic function. Extending the integral-equation (decomposition) approach to time-dependent coefficients, we derive a Volterra equation characterizing the early-exercise surface. The expectation in the decomposition formula is evaluated by two complementary spectral methods: a double cosine (COS) expansion of the transition density, and a damped-Sinc (DSINC) local-basis scheme that is more accurate and stays robust when a low Feller ratio or large vol-of-vol induces Gibbs oscillations in the COS series. Benchmarked against a penalty-iteration MCS-ADI finite-difference solver, both methods price a contract in about 1-2 seconds, roughly an order of magnitude faster than the finest finite-difference grid, while DSINC improves median accuracy over COS by about a factor of twelve. The experiments also show that the early-exercise surface is a substantially nonlinear function of the variance, contrary to the linear-in-variance approximation common in earlier work.

Keywords

Cite

@article{arxiv.2606.27335,
  title  = {Valuing American options and Flexible Forwards contracts in time-dependent models},
  author = {Leif Andersen and Andrey Itkin and Rakhymzhan Kazbek},
  journal= {arXiv preprint arXiv:2606.27335},
  year   = {2026}
}

Comments

57 pages, 8 figures, 6 tables