Hidden Risks and Optionalities in American Options

Paper: arXiv 2602.14350

Authors: Noura El Hassan, Bacel Maddah, Nassim N. Taleb

Abstract

We develop a practical framework for identifying and quantifying the hidden layers of risks and optionality embedded in American options by introducing stochasticity into one or more of their underlying determinants. The heuristic approach remedies the problems of conventional pricing systems, which treat some key inputs deterministically, hence systematically underestimate the flexibility and convexity inherent in early-exercise features.

Complexity vs Empirical Score

• Math Complexity: 5.5/10
• Empirical Rigor: 3.0/10
• Quadrant: Lab Rats — theoretically deep, empirically untested

Why this score: The paper provides a strong theoretical and heuristic framework addressing model fragility and hidden optionality in American options under stochastic carry rates. However, it relies heavily on historical practitioner anecdotes rather than rigorous empirical backtesting or statistical validation.

Research Flowchart

  flowchart TD
    A[Research Goal: Quantify hidden risks & optionality in American options] --> B[Input Determinants: Spot price, volatility, interest rates & dividends]
    B --> C[Methodology: Introduce stochasticity to deterministic option inputs]
    C --> D[Computational Engine: Heuristic pricing model with early-exercise logic]
    D --> E[Outcome 1: Corrects systematic underestimation of conventional pricing]
    D --> F[Outcome 2: Accurately captures Early Exercise Premium & Convexity Risk]