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Abstract

We study the HJM approach which was originally introduced in the fixed income market by David Heath, Robert Jarrow and Andrew Morton and later was implemented in the case of European option market by Martin Schweizer, Johannes Wissel, Rene Carmona and Sergey Nadtochiy. The main contribution of this thesis is to apply HJM philosophy to the American option market. We derive the absence of arbitrage by a drift condition and compatibility between long and short rate by a spot consistency condition. In addition, we introduce a forward stopping rule which is significantly different from the classical stopping rule which requires backward induction. When It^o stochastic differential equation are used to model the dynamics of underlying asset, we discover that the drift part instead of the volatility part will determine the value function and stopping rule. As counterpart to the forward rate for the fixed income market and implied forward volatility and local volatility for the European option market, we introduce the forward drift for the American option market.

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