American option-pricing by a method of error correction

The real-options approach often assumes that investment projects last indefinitely, which is an unrealistic assumption. When projects live finitely, valuation techniques from American option pricing are required. This paper presents a method for pricing American options based on the first-passage approach to the problem. The key is to correct the error associated to the price obtained from a rough, first approximation. The procedure leads to a significant reduction of the error corresponding to the initial approximation. As a particular case of the method proposed, we derive a closed-form approximation of the option price. The existence of a closed-form approximating formula (which does not involve iterative methods) keeps the computational cost low. In terms of accuracy, the method can be compared to much more sophisticated methods. A tight lower bound (given in closed-form) is also provided. The method is fast, accurate, flexible, and easy to implement. A spreadsheet suffices for practical implementation.