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Pricing and Hedging of Barrier Options

Michael Kateregga (michaelk@aims.ac.za) African Institute for Mathematical Sciences (AIMS)


Supervised by: Peter Ouwehand Stellenbosch University, South Africa

19 May 2011
Submitted in partial fulllment of a postgraduate diploma at AIMS

Abstract
Barrier options are the simplest of all exotic options traded on nancial markets. These instruments somewhat dier from vanilla or standard options in the sense that a predetermined barrier is considered that determines the pay-o of the option depending on whether the price of the underlying asset hits the barrier or not, before maturity. We derive mathematical formulae for pricing these options in the Black-Scholes environment. The whole edice of mathematical asset pricing is based on the idea of replication. We are able to price any derivative security only because we are able to construct a portfolio of assets whose value is exactly equal to the payo of the derivative at maturity a strategy known as delta-hedging. Since the prices of the assets are known so is the portfolio value and thus, the value of the derivative. For no arbitrage, the value of the replicating portfolio should be equal to that of the derivative security. However, frequent portfolio rebalancing is both costly and impractical. Therefore, we discuss the possibility of replicating a derivative security using a static (no rebalancing) portfolio of derivative securities static hedging strategy. We show and discuss how the static hedging strategy replicates a given derivative security better than the delta approach. Key words: Risk Neutral Valuation, Black-Scholes PDE, Heat equation, Method of images, Barrier options, Dynamic hedging, Static hedging, Hedging performance.

Declaration
I, the undersigned, hereby declare that the work contained in this essay is my original work, and that any work done by others or by myself previously has been acknowledged and referenced accordingly.

Michael Kateregga, 19 May 2011 i

Contents
Abstract 1 Introduction 1.1 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i 1 1 2 2 4 5 6 9 9

2 Options 2.1 2.2 2.3 2.4 Financial Markets: Terminology and Denitions . . . . . . . . . . . . . . . . . . . . . . Vanilla Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Put-Call Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3 Pricing Options 3.1 3.2 3.3 3.4 The Black-Scholes Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The Heat Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Method of Images . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Prices of Vanilla Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 16

4 Hedging 4.1 4.2 4.3 4.4 4.5

The Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Delta Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Static Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Hedging Performance/Error . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Further Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 27 28 30

5 Conclusion A Barrier Option Prices References

ii

1. Introduction
1.1 Motivation

Barrier options are a branch of exotic options, commonly traded on over-the-counter markets, that is, they are not recorded on stock exchange markets. They are usually between banks and corporations. Due to their advantages over ordinary vanilla options, many investors where attracted to-date to deal in them more than the vanilla options and for that matter there was need to obtain their valuation formulae as well as establishment of risk management strategies-hedging/replication to boost their trading. In this essay we derive the pricing formulae of the various simple barrier options and discuss and compare two dierent basic hedging strategies of these options. Merton (1973) [Mer73] was the rst to study the pricing of barrier options. He priced the down-andout barrier options by solving a transferred stochastic dierential equation with boundary conditions [Zha98]. Studies of barrier option pricing in the early seventies where rare until around 1983 when Bergman [Ber83] designed a frame work for pricing these options. They gained popularity and thus, became attractive to investors in around 1991 after a series of publications about their valuation. Barrier options are pathdependent options whose payos depend on a predetermined price known as the barrier level. Barrier options are activated or deactivated the moment the underlying stock price hits the barrier. When a barrier option is deactivated, the option holder receives nothing because the option has become worthless. These kind of options are known as knock-out barrier options. Before knocking-out, the option is termed still alive. Contrary to the knock-out barrier options are the knock-in options. These options are activated or become alive the moment the barrier level is hit. An investor who buys a knock-in option is only assured of a payo when the underlying stock price hits the barrier level. Barrier options are cheaper than ordinary options because of the barrier feature, they oer exibility in setting up the barrier level and thus, the cost of the contract. The nearer the underlying stock price is to the barrier, the cheaper is the knock-out and the more expensive is the knock-in option. This gives exibility to an investor in setting up a particular barrier according to what he expects of the future market, after all barrier options are tailor-made in the sense that they depend on the investors preferences. This makes barrier options so attractive to many investors. It is reected in [ZVF00] that the market of barrier options has been expanding rapidly, doubling in size since 1992 and in 1996, their market size was over 2 trillion dollars.[Hsu97] The rest of the essay is organised as follows: The next chapter introduces some basic terminologies of nancial markets. We discuss the Risk Neutral Valuation Relationship explaining its implication in option pricing, we also dene the dierent types of vanilla options and their relationship (put-call parity). Thereafter, we introduce, dene and classify barrier options. In chapter three we derive the well-known Black-Scholes PDE for pricing vanilla options discussing the applicability of the heat equation. The method of images in pricing simple barrier options in relation to the heat equation is briey discussed. Chapter four analyses the delta and static hedging strategies of barrier options and their hedging performances. We also discuss how we can reduce the hedge error in static hedging through optimization strategy. Chapter ve concludes.

2. Options
In this Chapter we shall dene some important concepts considered in pricing option derivatives on nancial markets. We discuss vanilla and barrier options reecting the dierences and similarities between them in terms of their payos.

2.1

Financial Markets: Terminology and Denitions

Unless otherwise stated, the parameters used in this essay are dened in table 2.1. In a simple Binomial Table 2.1: Denition of Parameters Symbol Denition S Stock Price K Strike Price B Barrier level P Put option Price C Call option Price t Current date/time T Expiry/maturity date Time to maturity t First barrier-hitting time Volatility r Risk-free interest rate Market Model, the stock price can move up by a factor u or down by a factor d in one time step (singleperiod). At any particular time t the model is assumed to be consisting of two assets, a deterministic bond Bt and a stochastic stock St . Thus, St is a risky asset whereas Bt is risk-free. In addition, St and Bt are strictly positive. 2.1.1 Denition. A derivative is a security whose price ultimately depends on that of another asset called the underlying. 2.1.2 Rate of Return. [CZ02] The rate of return or simply return on stock and bond is dened as ST S0 BT B0 on stock, and KB = on bond. S0 B0 2.1.3 Denition. Volatility is a measure of dispersion around the mean or average return of a security derivative. KS = Constant volatility implies that the daily variations are drawn from the same distribution with a known variance. [Tal96] 2.1.4 Denition. [Bjo09] A portfolio is a vector h = (x, y) consisting of x number of bonds and y stocks held by an investor at a particular time. The values, x and y can assume both negative and positive values where a positive value implies buying (taking a long position) and a negative value implies selling (taking a short position). In other words an investor is allowed to buy or sell bonds (shares) at any one time t. 2

Section 2.1. Financial Markets: Terminology and Denitions 2.1.5 General Assumptions in Financial Markets. [Bjo09] We assume the following:

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(i) Short positions and fractional holdings are allowed. That is, every h R2 is an allowed portfolio. (ii) There are no transaction costs of trading. (iii) The market is completely liquid in the sense that an investor can buy or sell any quantity of the asset without inuencing its price. Thus, one can borrow unlimited amounts of money from the bank by short selling bonds. (iv) There is no bid-ask spreads. The selling and buying prices are equal for all assets. 2.1.6 No-arbitrage Principle. [Bjo09] An arbitrage is a portfolio which: (i) costs nothing to construct, (ii) has strictly a positive probability of making a prot and, (iii) has zero probability of making a loss. Hence, an arbitrage strategy is like a free lottery ticket. Arbitrage opportunities are so attractive and thus, the moment they appear, they are quickly grabbed and nothing is left. When pricing we try to ensure that there is no such opportunities. 2.1.7 Denition. [Bjo09] A probability measure Q is called a martingale measure if the following condition hold; S0 = (1 + r)1 EQ ST , (2.1.1)

where r is the risk-free interest. Equation (2.1.1) implies that under a martingale measure Q, the discounted expected stock price S1 at time step 1 is equal to the stock price at t = 0. A market is termed arbitrage free if and only if there exists a martingale measure Q. The proof to justify this can be obtained from [Bjo09]. 2.1.8 Denition. A contingent claim also a nancial derivative is a stochastic variable X of the form X = (Z) where Z is the stochastic variable driving the stock process. 2.1.9 Denition. A contingent claim is a nancial contract that pays a possibly random amount X at a predetermined time T . h VT = X, with probability 1. Thus, portfolio h is termed as a hedging or a replicating portfolio of the contingent claim. Loosely, for any market such that all claims can be replicated is termed a complete market. 2.1.10 Risk Neutral Valuation Relationship. (RNVR) is a technique for determining the price of an option where the current price of an option is the expectation of its discounted future payo, conditional on current information. The expectation is done under a risk-neutral measure Q, under which all the discounted underlying asset price processes are martingales. A risk neutral measure Q is a probability measure with the property that all assets have the same expected rate of return, i.e. the same rate of return as the bank account, which is the risk-free rate: EQ ST S0 =r S0 = EQ [ST ] = (1 + r)S0 .

Section 2.2. Vanilla Options

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h Under such a measure Q, any portfolio h will then also have expected rate of return r, i.e. EQ VT = h . Now if h is a replicating portfolio for an option X, i.e. if V h = X (with probability 1), (1 + r)V0 T T then also V0h = X0 , or else there will be arbitrage: This is the Law of One Price [CDKS04]. To best understand the Law of one price, let us consider the following example; Suppose a portfolio h such that (V0h > X0 ) at time t = 0, we short h and buy X and invest the dierence (V0h X0 > 0) in the bank. h At time t = T , we owe VT but we receive XT so the two cancel out. Thus, from the bank we have a h X )(1 + r) > 0 at no cost. sure prot of (V0 0

Similarly, if V0h < X0 , then we buy h and short X, for an initial positive cash ow of X0 V0h . Therefore, we have X0 = V0h
h = (1 + r)1 EQ VT

= (1 + r)1 EQ [XT ] In this essay we shall price options under Risk-Neutral Valuation Relation (RNVR) in Black-Scholes frame work. The expected return is set to be equivalent to the risk-free interest rate for no arbitrage. Therefore, the option written against the asset trades for the same price in a risk neutral economy as it would in a risk averse economy since it does not depend on the investors risk preferences any way.

2.2

Vanilla Options

An option is a contract between two parties, a buyer and a seller that gives the holder the right but not the obligation to exercise at a particular time. There are two types of options namely, a call and a put option. The call option gives the buyer the right but not the obligation to exercise whereas the put gives the seller the right but not the obligation to exercise. There are basically two kinds of options. The European-type and American-type. 2.2.1 Denition. [CZ02] A European call (put) option is a contract giving the holder the right but not the obligation to buy (sell) an asset known as the underlying, for a price K xed in advance, known as the strike price, at a specied future time T , called expiry time. Therefore, options are security derivatives. Suppose the underlying stock price at maturity is ST , then the payo of a European call is given as a function f (ST ) dened as [CZ02], f (ST ) = The payo of a European put is given as, f (ST ) = (K ST ) 0 if K > ST . otherwise (2.2.2) (ST K) 0 if ST > K . otherwise (2.2.1)

It is certainly clear that a pay-o function is non-negative. Thus, options can not be free, a premium (C for a call and P for a put) has paid when purchasing an option other wise the holder would under no circumstances lose money but instead acquire prot in case the payo turned out to be non-zero at maturity which violates the no-arbitrage principle.

Section 2.3. The Put-Call Parity

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Since the underlying stock price is random, the payo function f (ST ) is a random variable contingent on the price ST of the underlying on the exercise date T . Therefore, options are also referred to as contingent claims. Let us dene the function Ia>b as, Ia>b = 1 0 if a > b otherwise

Due to the premium paid initially, an investor who buys a European call option is entitled to a total gain of (ST K)IST >K CerT at time T and for a put, a total gain of (K ST )IK>ST P erT . And in turn, the writer of the call option gains CerT (ST K)IST >K whereas the one for a put gains P erT (K ST )IK>ST where r denotes the risk-free interest rate [CZ02]. This is illustrated in gure 2.1.
Call option
Payoff Gain

30

20

Put option
Payoff Gain

25 15

20

Payoff/Gain

15

10

Payoff/Gain

10

K
0

10

20

Stock price ST

30

40

50

10

20

Stock price ST

30

40

50

(a) Call option

(b) Put option

Figure 2.1: Vanilla options payos

2.3

The Put-Call Parity

The put-call parity denes the vital relationship between a call and a put option. The following theorem explains the relationship [CZ02]. 2.3.1 Theorem. (Put-Call Parity) For a non-dividend paying stock, the prices of European call and put options with the same strike K and maturity T , are related by the equation, S + P C = KerT (2.3.1)

Proof. Let us consider two portfolios 1 and 2 . Suppose portfolio 1 contains one call C at time t = 0 and portfolio 2 contains one put P and stock S. Then the dynamics for 1 are as follows, t=0 C + Ke
rT

t=T K + (ST K)IST >K

Market state at T K or ST

Section 2.4. Barrier Options

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At time t = T the value of 1 will take on value K if K > ST or ST if ST > K. For portfolio 2 we have the following dynamics, t=0 P +S t=T ST + (K ST )IST >K Market state at T K or ST

Similarly, we observe the same market status at time t = T for portfolio 2 . Since the values of 1 and 2 are the same at t = T then their values must be the same also at time t = 0 by law of one price. Hence, C + KerT = P + S, which is the Put-Call Parity. We can use PutCall parity to easily relate the prices of options. A call option is said to be in-the-money, at-the-money and out-of-money at any particular time t if (St > K), (St K) and (St < K) respectively. Similarly, for a put option the respective conditions are: (K St ), (K St ) and (K < St ).

2.4

Barrier Options

Barrier options are extensions of vanilla options in the sense that they have a barrier level which activates or deactivates the options pay-o upon hitting the barrier. The barrier can be hit when the option is in-the-money or out-of-money. Barrier options which are activated (become alive) upon hitting the barrier are called Knock-in barrier options or simply Ins and those that are instead deactivated (become worthless) are known as Knock-out barrier options or Outs. In knock-out options, if the barrier is not hit by the underlying price from the time of issuance of the option to its maturity, then the option holder receives an equivalent pay-o of a vanilla option. Knock-in options only provide a possibility of a positive payo after the barrier has been hit. There are two types of barriers with respect to the underlying stock price1 . The up-barrier, where the barrier level is greater than the current underlying price and the down-barrier for which the barrier level is below the current underlying stock price. When a barrier option knocks-in, it becomes an equivalent vanilla option and thus, oers the same pay-o whereas a knock-out is equivalent to the corresponding vanilla option as long as the barrier is not hit until maturity (exercise time). Let us dene MT := max{St : t T } and mT := min{St : t T }, then the payos of down-and-out call (DOTC) and down-and-out put (DOTP) are given by [Jia03] DOT C : (ST K)+ I{mT >B}
+

(2.4.1) (2.4.2)

DOT P : (K ST ) I{mT >B}

The payos for the up-and-out call (UOTC) and up-and-out put (UOTP) are given as follows U OT C : (ST K)+ I{MT <B} U OT P : (K ST )+ I{MT <B} Knock-in options give a payo equivalent to that of an equivalent vanilla option at maturity only when the barrier is hit otherwise the payo is zero.
1

The other type of barrier that depends on time is the maturity which we discuss later under static hedging.

Section 2.4. Barrier Options

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A portfolio consisting of one knock-in call and one knock-out call is equivalent to an ordinary call option, that is, up-and-out call + up-and-in call = vanilla call Similarly, for the other barrier options we have the following relationships, down-and-out call + down-and-in call = vanilla call up-and-out put + up-and-in put = vanilla put down-and-out put + down-and-in put = vanilla put Figure 2.2 shows the relationship between barrier and ordinary options. Panel (a) (barrier level = $80 and strike = $100) shows a down-and-out call. We observe that when the underlying stock hits the barrier at $80 and below, it is worthless. However, as the stock price increasingly moves away from the barrier, the down-and-out call option value almost matches perfectly with the ordinary vanilla call because the probability that the underlying stock price will hit the barrier reduces. Panel (b) shows an up-and-out put (barrier level = $120 and strike = $100). The up-and-out put matches the vanilla put option for stock prices smaller than the barrier. As the underlying price approaches the barrier, we observe a dierence in values and the barrier option value becomes zero at and above the barrier. Panel (c) shows that as we approach the barrier, the down-and-in call option value increases because of increased probability that it will knock in. At the barrier, the value of a down-and-in call is exactly equal to that of an ordinary call. After hitting the barrier, a knock-in call become equivalent to an ordinary call and pays o an equivalent value. Panel (d) suggests a close-to-zero value of a down-and-in put and a gradual increase in value as we approach the barrier. We also observe that the price of a down-and-in call is slightly smaller than that of the vanilla put but at low stock prices the two match up well. Panels (e) and (f ) show knock-outs, their values decreases as we approach the barrier and become worthless at the barrier. At low underlying prices, an up-and-out call behaves exactly like a vanilla call whereas a down-and-out put behaves exactly like a vanilla put at high underlying prices far from the barrier. (2.4.3)

Section 2.4. Barrier Options

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Vanilla and Down-and-out Call, Barrier = $80, strike = $100 50


Down-and-out call Vanilla call
40

50 40

Vanilla & Up-and-out Put, Barrier = $120, strike = $100


Vanilla Up-and-out Put

Option value

30 20 10 0 50

Option value
60 70 80 90 100 110 120 130 140

30 20 10 0 50

Underlying stock price ($)

60

70

Underlying stock price ($)


(b) up-and-out put

80

90

100

110

120

130

140

(a) down-and-out call

30

Vanilla & Down-and-in Call, Barrier = $110, strike = $120


Vanilla Down-and-in Call

50 40

Vanilla and Down-and-in Put, Barrier = $120, strike = $100


Down-and-in Put Vanilla put

25 20 15 10 5 0 50

Option value

Option value
60 70 80 90 100 110 120 130 140

30 20 10 0 50

Underlying stock price ($)


(c) down-and-in call

60

70

Underlying stock price ($)


(d) down-and-in put

80

90

100

110

120

130

140

50 40

Vanilla & Up-and-out Call, Barrier = $130, strike = $100


Vanilla Call Up-and-out Call

50 40

Vanilla & Down-and-out Put, Barrier = $70, strike = $100


Vanilla Down-and-out Put

Option value

30 20 10 0 50

Option value
60 70 80 90 100 110 120 130 140

30 20 10 0 50

Underlying stock price ($)


(e) Up-and-out call

60

70

Underlying stock price ($)

80

90

100

110

120

130

140

(f) Down-and-out put

Figure 2.2: Barrier and Ordinary Options

3. Pricing Options
In this chapter we briey introduce Black-Scholes PDE, reducing it to a more simplied and easy-tosolve heat equation, derive option prices for ordinary European options and barrier options employing the method of images and put-call parity.

3.1

The Black-Scholes Model

The Black-Scholes model (Black and Scholes, 1973) is a well known model for pricing derivative securities, where the price of the option depends on the regular Black-Scholes parameters; S, T, , K and r. For the case of barrier options, we introduce another parameter, B, the barrier level in addition to the above stated parameters. Our objective is to derive the valuation formulae for barrier options in a Black-Scholes environment. Living in Black-Scholes world implies that the stock price evolution follows a log-normal distribution with constant volatility. We assume that there are no transaction costs and the market is perfectly liquid1 . In addition, trading is continuous and the interest rate and dividend yield are taken to be continuous and constant over the options life time. These assumptions, though simplify the pricing process of options, do not reect real markets. However, other models have been designed basing on the Black-Scholes as the benchmark to closely model the markets. 3.1.1 Denition (Brownian Motion). [Jia03] A Brownian motion also known as a Wiener process, is a continuous-time stochastic process Wt , t 0 that satises the following properties; (i) Continuity of path : W0 = 0 (ii) Normal increments: For any t > 0, Wt N (0, t), and for 0 s < t, Wt Ws is normally distributed with mean 0 and variance t s, that is, Wt Ws N (0, t s) (iii) Independence of increments: For any choice of ti [0, T ] with 0 < t1 < t2 < < tn , the increments Wtn Wtn1 , Wtn1 Wtn2 , , Wt2 Wt1 and Wt1 are independent. Consider a non-paying dividend stock with constant volatility, and a constant risk-free interest rate, r. The stock price evolution is dened as : dSt = r dt + dWt . St (3.1.1)

where Wt is the Brownian Motion. St is the stock price and dSt denotes the change in stock price at time t. The solution to equation (3.1.1) is given as [WDH94], St = S0 exp (r 2 /2)t + Wt . Figure 3.1 shows some sample stock price evolutions for a period of 21 days. Since Wt is normally St distributed, the log-return, dened as log S0 , of the underlying asset is normally distributed with mean (r 2 /2)t and variance 2 t. Therefore, the density function of the log-return is given as 1 (x t)2 f (x) = exp 2 2 t 2t , (3.1.2)

Selling and buying any quantity of the asset without inuencing its price.

Section 3.1. The Black-Scholes Model

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500 450 400 350 stock price 300 250 200 150 100 500 100

Stock Price evolution

200 300 Time(hours)

400

500

Figure 3.1: Some possible stock evolution for a period of 21 days from now. where = (r 2 /2) and x = ln(St /S0 ). Equation (3.1.2) is known as the unrestricted distribution of return on the underlying asset since it only depends on the initial condition S0 and no any other conditions. 3.1.2 Lemma (Its Formula). Given a twice-dierentiable function F (St , t) of St and t where St o follows a stochastic dierential equation dSt = at dt + t dWt , then dFt =
2 F F 1 2 F dSt + dt + 2 St 2 dt. St t 2 St 2 1 F F F 2 F + 2 St dt + = at + t dWt . 2 St t 2 St St

(3.1.3)

Options are written against assets whose values depend on the underlying assets price. Therefore, the option value V (S, t) satises Its formula since the asset price evolution is stochastic. For constant o risk-free interest rate and volatility we write V V 1 2V dt + dS + 2 S 2 dt. (3.1.4) t S 2 S 2 Let us consider a simple portfolio consisting of one long position on the option worth V (S, t) and a short position in t shares of stock, where t is a changing function of time called the hedge ratio. The total value of this portfolio is thus dV = (S, t) = V (S, t) t S. It follows from equations (3.1.4) and (3.1.5) that d(S, t) = dV (S, t) t dS = V 1 2V + 2S 2 t 2 S 2 (3.1.5)

dt +

V t S

dS.

(3.1.6)

Section 3.2. The Heat Equation

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The rst term on the right hand side of equation (3.1.6) is deterministic while the second term is stochastic thus, if we set t = V we eliminate this stochasticity obtaining S d(S, t) = V 1 2V + 2S 2 2 t 2 S dt. (3.1.7)

We have now established a portfolio that gives an instantaneous risk-less return, risk-less, because the dWt -term is zero. This risk-less return must then be the same as the risk-less rate r otherwise, an investor can borrow at a lower rate, and invest at a higher rate thereby making risk-free money which violates the arbitrage principle. Thus, d(S, t) = r(S, t) dt. Thus, taking t =
V S

and using equation (3.1.5), equation (3.1.7) becomes V 1 2V + 2S 2 t 2 S 2 dt.

r(S, t) dt = r(V t S) dt = V S

r V S

dt =

V 1 2V + 2S 2 t 2 S 2

dt.

(3.1.8)

Rearranging equation (3.1.8) gives us the well-known Black-Scholes equation (3.1.9) for pricing derivative securities. V 1 2V V + 2S 2 + rS rV = 0. 2 t 2 S S (3.1.9)

The derivatives price at any instant should satisfy equation (3.1.9) under certain boundary conditions. For example, the price (t) = V (St , t) of a still-alive up-and-out barrier option satises equation (3.1.9), with boundary conditions V (B, t) = 0 (for t < T , knock-out at the barrier), V (ST , T ) = g(ST ) (Pay-o, at maturity). and V (St , t) St as St . The value of an option with payo g(ST ) at maturity, T under risk-neutral valuation relation and a martingale measure Q is given as V (S) = erT EQ [g(ST )] = erT
0

g(ST )f (ST ) dST

from equation (3.1.2)

(3.1.10)

Thus, we can obtain the option value by simply computing the expectation of the discounted pay-o function, where f (ST ) is obtained from equation (3.1.2).

3.2

The Heat Equation

Prices for vanilla and barrier options can be derived by reducing the boundary problem in equation (3.1.9) to a more simplied form, the heat equation. To do this, we shall need to rescale S and t by

Section 3.2. The Heat Equation

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introducing new variables dened as x and such that S = Kex and t = T 2 / 2 [WDH94]. we obtain V 2 V V = = t 2 (T 22 ) V V 1 V = = x) S (Ke Kex x 2V V 1 V 2V = 2 2x = + S 2 S S K e x x2 Substituting equation (3.2.1) in equation (3.1.9), we obtain; V V 2r V 2V 2r + 2 + 2 V = 0. 2 x x x

(3.2.1) .

(3.2.2)

Now suppose the function V (S, t) = Kex+ u(x, ) satises equation (3.2.2), then V u = Kex+ u + Kex+ V u = Kex+ u + Kex+ x x 2 2V u u = 2 Kex+ u + 2Kex+ + Kex+ x2 x x2

(3.2.3) .

Substituting equation (3.2.3) in equation (3.2.2) bearing in mind that ex+ = 0, we obtain, u + u u + u x + 2 u + 2 u 2 u + x x2 + 2r 2 u + u x 2r u = 0. 2 (3.2.4)

We can now clearly see the terms for the general heat equation. The task is now to eliminate the terms u and u by making their coecients equal to zero. These coecients are given respectively as: x Coeu : ( + ) + 2 + we get = 1 (k1 1) and = 2 equation,
1 4 (k1

2r ( 1) and 2

Coe u : 1 + 2( +
x x

r ). 2

1 Obtaining suitable values for and such that Coeu = 0 and Coe u = 0 and setting k1 = r/ 2 2 ,

+ 1)2 and equation (3.2.4) reduces to the well-known heat u 2u = . x2

(3.2.5)

Section 3.3. Method of Images

Page 13

From the assumption V (S, t) = Kex+ u(x, ) and (K > B) we obtain the new conditions to our transformed problem as follows, u(x, ) = 1 V (S, t)e(x+ ) K 1 u(x, 0) = V (S, T )ex K 1 = max(S K, 0)ex K 1 = max(Kex K, 0)ex K = max(ex 1, 0)ex = max e

1 (k +1)x 2 1

(3.2.6) , 0 := u0 (x), x > log


B K

1 (k 1)x 2 1

, (from S > B), as x ), and

u log

u(x, ) e(1)x
B K

= 0,

at the barrier.

as x

(since V (S, t) S = Kex

(3.2.7)

Condition (3.2.7) is a boundary condition, to solve the heat equation problem we must ensure that it is a well-posed Initial Value Problem (IVP). We can change the boundary condition (3.2.7) into an initial condition by using the method of images as we see later. The Black-Scholes equation has been reduced to the heat equation whose general solution is given as [WDH94] 1 u(x, ) = 2

u0 (s)e(xs)

2 /4

ds.

(3.2.8)

We evaluate the integral in equation (3.2.8) by making the substitution x = (x s)/ 2 then turn back to the initial variables to obtain the Black-Scholes value of an ordinary call option given below as [WDH94], V (S, K) = SN [d+ (S, K)] Ker N [d (S, K)] where,
S ln( K ) + (r ) 2 d (S, K) = S ln( K ) + = d+ (S, K) = d (S, K) + .
2

(3.2.9)

(3.2.10)

From the put-call parity, the value of an ordinary put option is given as P = Ker N [d (S, K)] SN [d+ (S, K)]. Barrier option prices can be obtained from the heat equation by using the method of images we discuss in the immediate following section.

3.3

Method of Images

This method relates to the ow of heat in an innite bar. It involves solving an innite problem made up of two semi-innite problems with equal and opposite initial temperature distributions, that is, one half

Section 3.4. Prices of Vanilla Barrier Options

Page 14

is hot and the other is cold [WDH94] with net temperature at the junction being zero. The condition B u(log( K ), ) = 0 in the heat problem reects a semi-innite-bar problem. So, we can solve the B innite-bar problem and then relate it to a semi-innite bar held at zero temperature at x = log( K ). Equation (3.2.5) shows that heat ow in a bar is invariant under translation and reection, thus, if u(x, ) is a solution, so is u(x + x0 , ) and u(x, ) where x0 is an arbitrary constant. Therefore, B with x0 = log( K ), reecting the initial condition u(x, 0) about x0 (by the reection principle) denotes,
B u (x, 0) = u0 (2 log( K ) x),

(3.3.1)

Thus, for barrier options, instead of solving equation (3.2.5) with conditions (3.2.6) to (3.2.7), we solve equation (3.2.5) conditioned by, u(x, 0) =
B u(log( K ), 0) = 0.

max(e 2 (k1 +1)x e 2 (k1 1)x , 0); max(e


B 1 (k1 +1)(log( K ) 2 x)

for , 0);

B (k1 1)(log( K ) 1 x) 2

B x > log( K ))

for

B x < log( K )),

(3.3.2)

3.4

Prices of Vanilla Barrier Options

The barrier feature of these options activates or deactivates their payos. In the ins options, the option holder is assured of an equivalent vanilla option pay-o as long as the barrier is hit (activated) whereas for the case of outs the option becomes worthless the moment the barrier is hit (deactivated). We consider barrier options with zero rebates. 3.4.1 Down-and-out Call. Let us consider the scaling, C(S, K) = Kex+ u(x, ), where C(S, K) denotes the vanilla call option price given by equation (3.2.9). Suppose u1 is a solution to the heat equation (3.2.5), then u1 (x, ) =
C(S,t) (x+ ) . K e

(3.4.1)

From equation (3.4.1) and symmetry of the reection principle, we obtain the price of a down-and-out call option [WDH94] as, DOT C = Kex+ [u1 (x, ) + u2 (x, )] . where u2 (x, ) denotes the solution to the problem with antisymmetric initial data with respect to that of u1 . Hence, due to invariance under reection and translation we write, DOT C = Kex+ [u1 (x, ) + u2 (x, )] = Kex+

= Ke log( K )+ = C(S, K) = C(S, K) = C(S, K) = C(S, K)

B u1 (x, ) u1 (2 log( K ) x, )

C(S,K) ( log( S )+ ) K e K

2 C( B ,K) (2 log( B )log( S )) ) S K K e K

2 C( B ,K) 2(log( B )log( S )) S K K e K 2 2 S C( B , K) B S 2 S (k1 1) C( B , K), Since B S 2 2 S 2/ C( B , K), where B S

= 1 (k1 1) and k1 = 2 = (r
2 2 ).

r 2 2 ,

(3.4.2)

Section 3.4. Prices of Vanilla Barrier Options

Page 15

We have managed to obtain the price of a down-and-out call in equation (3.4.2), therefore using the put-call option parity (S + P C = Ker ), we can as well obtain the option price for a down-and-out put, DOT P . However, in deriving equation (3.4.2) we considered a case (K > B), so what about (K < B)? There is a signicant relationship between the strike K and the barrier B in barrier option pricing. The procedure for pricing the option depends on whether the strike is greater than the barrier or not irrespective of the level of the underlying price. Peter G. Zhang [Zha98] discusses this in details where he introduces a digital number IB>K dened as: IB>K = 1; 0; if B > K otherwise.

The general pricing formulae are as given in the appendix A. Barrier options are very attractive to traders because they are relatively cheaper compared to their equivalents (ordinary options). Table 3.1 shows some prices of an ordinary put, up-and-in and up-andout put options with the barrier level at $130. The strike is considered to be always at-the-money. As we approach the barrier, the value of an up-and-in put increases tending to that of an ordinary put. This is because of the increased chance that it will become alive. At the barrier the value of an up-and-in put is exactly the same as that of an ordinary put, at this instant, we say, the up-and-in put is aliveand thus has a payo equivalent to that of an ordinary put at maturity. The up-and-out put loses value as we approach the barrier due to the increased probability that it will hit the barrier and become worthless. At the barrier, this option has zero value. However, before hitting the barrier its termed still alive. Its trivial to see that the sum of values of an up-and-out and up-and-in puts is equal to the price of the ordinary put option. This follows from the put-call parity as discussed earlier on. Table 3.1: Barrier and Ordinary Options Prices Stock price ($) 120 122 124 126 128 130 Volatility = 15% Ordinary Put ($) 4.457521 4.531813 4.606105 4.680397 4.754689 4.828981 Strike : at-the-money Up-and-in Put ($) 0.915784 1.380203 1.994826 2.773456 3.720384 4.828981 Risk-free rate = 5% Up-and-out Put ($) 3.541737 3.151610 2.611279 1.909694 1.034305 0.0 Maturity = 1 year

4. Hedging
In this chapter we discuss the delta and static hedging strategies of barrier options. The delta hedging involves frequent rebalancing of the portfolio. In static hedges the portfolio is constructed once and for all, no rebalancing but hedging options have varying maturities and strikes. The idea of hedging is that an investor can hold a portfolio of simple options that will provide him the same payo of a barrier option as one who would have bought the barrier option itself. We shall present the hedging performance/errors of the hedging strategies towards the end of the chapter.

4.1

The Greeks

The Greeks are a measure of the sensitivities of the option value with respect to the changing value of a particular parameter. The parameters include, volatility, risk-free interest rate, the underlying stock price, and time to maturity. We obtain the Greeks of barrier options by taking derivatives of their pricing formulae with respect to the concerned parameters. Hedging is the technique that traders use to protect themselves against risk by carefully taking particular positions (buying and/or selling) in the market. Hedgers always wish to possess a portfolio (stocks and bonds for example) whose value is equivalent to a particular option of interest. In the real world, perfect hedging is an ideal phenomenon in the sense that any hedging strategy will always have some hedge error (the dierence between the hedging portfolio value and the target option value). These errors tend to arise from market imperfections, which tend to complicate hedging. There are basically two hedging methods that are common and well-known; delta- or dynamic hedging, and static hedging.

4.2

Delta Hedging

The delta () is a measure of sensitivity of the changing option value V with respect to the changing underlying stock price S. = V . S (4.2.1)

Figure 4.2 compares the deltas of knock-out options with those of ordinary options. Generally we observe that near the barrier, the graphs of the knock-out options have kinks. This is what complicates hedging of these options near the barrier. Equation (4.2.1) is normally expressed as a percentage. Delta hedging aims at obtaining V = 0. As an example, the delta DIN C of a down-and-in call option (with B < K) S is obtained by dierentiating equation (A.0.5) with respect to the underlying stock price S to obtain [Zha98], DIN C (S, K, B) =
2 B 2/ S

B2 S2

N d+

B2 S ,K

2 C S 2

B2 S ,K

(4.2.2)

One can delta-hedge in the following two ways: Buy an option and sell -shares of stock and invest the rest of the money in a risk-free nancial institution such as a bank.

16

Section 4.2. Delta Hedging

Page 17

Delta: Vanilla & Up-and-out Put, Barrier = $125, strike = $100 0.0
Vanilla Put Up-and-out Put
0.2 0.4

Delta: Vanilla & Down-and-out Call, Barrier = $80, strike = $100 1.0
Vanilla Call Down-and-out Call
0.8 0.6

Delta

0.6 0.8 1.0 50

60

70

Underlying stock price ($)

80

90

100

110

120

130

140

Delta
0.4 0.2 0.0 50 60

70

Underlying stock price ($)

80

90

100

110

120

130

140

(a) Up-and-out put and Ordinary put

(b) Down-and-out call and Ordinary call

Sell an option and use the premium to buy -shares of stock and invest the rest in the bank. Either way, we obtain a portfolio subjective to continuous adjustments (rebalancing) in its contents to ensure its (ideal) delta-neutrality at all times. Suppose an investor sells 5 calls worth 10 with the underlying stock price at 100, then he earns a premium of 5 10 = 50 and has to buy stock worth 5 100 = 500. Therefore to hedge himself, he instead buys 500 = 0.4 500 = 200 shares (where = 0.4). This sets his delta position on option to 200 and on stock to +200. Thus, his hedged position is zero. Since the delta depends on stock price, its under continuous change. Hence, the investor has to adjust his portfolio continuously by selling or buying shares which is actually impossible1 . Assuming the delta increases from 0.4 to say 0.5, then the investor has to buy more (0.5 0.4) 500 = 10 shares by borrowing money from the bank. However, if the delta drops to 0.35, he sells (0.35 0.4) 500 = 25 shares by invests the money in the bank. Thus, for a short position in the option, an increase in stock price, leads to an increase in delta with a loss on the option and a gain on stock while a decrease in stock price causes a decrease in delta followed by a gain on the option and a loss on the shares by equal amounts. This makes the hedgers portfolio delta-neutral. The continuous change in delta arises from the fact that stock price is a continuous stochastic process. We can not predict what the stock price will be tomorrow by using the available information. Figure 3.1 on page 10 shows some 20 sample paths of stock evolution from today for a particular period of time. Let us consider hedging a down-and-out call option, strike 100, and barrier at 80 for a period of 21 days. The risk-free interest rate, r = 8%, dividend yield, d = 0 and volatility, = 20%. The delta of this barrier option for any underlying stock price S, is computed from the formula in equation (4.2.2) for a down-and-in call option by using put-call parity given in equation (4.2.3) and its theoretical value from equation (A.0.5). DOT C = vanilla DIN C .
1

(4.2.3)

One of the loop holes of delta hedging.

Section 4.2. Delta Hedging Thus, the down-and-out call has a delta function given by [Zha98] DOT C = N [d+ (S, K)]
2 B 2/ S

Page 18

B2 S2

N d+

B2 S ,K

2 C S 2

B2 S ,K

(4.2.4)

The delta hedging process for this down-and-out call option is presented in the table 4.1 assuming stock evolution in (column 2). At day zero, the Black-Scholes theoretical price of a down-and-out call option

Table 4.1: K = 100, B = 80, = 20%, T = 21 days, r = 8%, d = 0.0% is 12.002459 (column 8). The value of delta is 0.70717 and the underlying stock price is 100. Thus, we can hedge our position by borrowing (0.70717 100 12.002459 = 58.714541) money from the bank to buy 0.70717 shares at 100 each. This creates a debt worth 58.714541 in the bank, (column 6). On the next day, day = 1, the underlying price value increases to 100.33 and delta value to 0.71178. To maintain the hedge, therefore, we need to buy more shares worth the dierence (0.71178 0.70717 = 0.00461) at the new price 100.33 each. Thus, we again borrow money worth (0.00461 100.33) taking the total bank account value to ((58.714541e0.08/365 ) (0.00461 100.33)) = 59.1899327. This increases the cumulative costs in the bank. We observe a further increase in delta on the second day too, hence we buy the dierence in delta. However, on the third day, the value of delta drops to 0.69908 and the stock price is 99.54, In this case we sell 0.674080.71647 = 0.01739 shares at 99.54 each and invest the money in the bank reducing the cumulative costs to 57.957083. This process is repeated until maturity or when the barrier level is hit. However, in this particular example, the barrier of 80 is never hit until maturity. We observe that our replicating portfolio (column 7) and the option price (column 8) almost match perfectly and thus, at maturity, the hedging portfolio almost has the same payo as the barrier option and so we are hedged from massive exposure. This is illustrated in gure 4.1.

Section 4.2. Delta Hedging

Page 19

12.5 12.0 11.5

Delta Hedging
Hedging Portfolio Barrier Option

Option value

11.0 10.5 10.0 9.5 9.00 5

Days

10

15

20

Figure 4.1: Delta hedging a down-and-out call The idea of hedging shows us that instead of a buying a barrier option, an investor can instead hold a portfolio of just cash and shares and still benet or lose by the same much as he would have with a barrier option. Table 4.2 shows a scenario where the barrier is hit at 90 during the hedging process. At barrier, the hedging process is terminated since the down-and-out barrier option is now worthless. At this moment we liquidate our portfolio and settle the bank position.

Section 4.3. Static Hedging

Page 20

Table 4.2: K = 100, B = 90, = 20%, T = 21 days, r = 5%, d = 0.0%

4.3

Static Hedging

Static hedging involves the construction of a portfolio that contains the underlying call option (could be a put) and other options (calls and/or puts) with dierent expiry dates, same strikes and with xed weights. This portfolio is such that it replicates the value of the target option for any underlying stock price for a wide period of time before maturity, without any need for rebalancing (changing the weights). We require that the value of this hedging portfolio is the same as that of the target option at the barrier and maturity. Unlike dynamic or delta-hedging, in static-hedging, the risk and costs are minimized in the sense that the investor does not have to trade during the options life span. Once the portfolio is constructed at time t = 0 there is no more trading except at maturity or when the underlying hits the barrier, at which time the portfolio must be closed out. In the replication of barrier options, the barrier acts as a boundary upon which a boundary condition is imposed. Derman et al. explained two types of boundaries considered during replication; the stock price boundary, which is divided into upper boundary (up barrier) and the lower boundary (down barrier), and the time boundary (expiration date). The idea is to construct a portfolio of ordinary options such that the value of this portfolio is exactly the same as that of the target option at the boundaries. This is achieved by taking positions in calls and/or puts such that the portfolio value matches exactly the value of the target option at the boundaries. Derman et al. [DKE94] suggests that the portfolio for the above-boundary should consist of ordinary calls with strikes on or above the barrier to ensure that the replicating options always have zero payo within the boundary. Otherwise this would alter the

Section 4.3. Static Hedging replication strategy.

Page 21

However, positions are taken in puts with strikes on/or below the barrier for the lower-boundary, while a portfolio of both calls and puts with suitable strikes is constructed to replicate the target option at the time/expiry boundary. For instance, let us consider an up-and-out barrier call option with specications recorded in the table 4.3 below. Table 4.3: An up-and-out Call Option Stock price: Strike: barrier Time to expiration: Volatility: Risk-free rate: Up-and-out call value = 1.73027 110 110 130 1 year 15% per annum 5% per annum Ordinary call value = 8.07056

By denition, an up-and-out call option is one which becomes worthless the moment the underlying price hits the barrier. Otherwise2 , it pays o an equivalent value of an ordinary call option at maturity. We wish to construct a portfolio of ordinary options that behaves very like this [DKE94]. From table 4.3, at the stock price of $110, the value of the barrier option is $1.73027 and that of an ordinary call is $8.07056 with 1 year to maturity. In an attempt to replicate the barrier option, a portfolio of only one call produced the results recorded in table 4.4, Table 4.4: Portfolio of one call Strike Expiration Stock at 110 110 1 year 8.07056

Quantity 1

Type Call

Stock at 130 23.55498

Results in table 4.4 are very far from those of the barrier option. We obtained a portfolio value of $23.55498 at the barrier instead of $0 and in addition, its value at a stock price of $110 is dierent from that obtained in table 4.3. In the proceeding sections, we shall present the procedure of how this portfolio can be adjusted to possess similar behaviours as our target option. 4.3.1 DEK-Static Hedging. The discussion in this section follows from Derman et al (1995). The concept of static hedging derive from the principle of superposition which we dene as follows. Let us consider a linear operator D from the Black-Scholes PDE given in equation (3.1.9) in chapter 3 : D=
2 1 2 + rSt + 2 St 2 r. t St 2 St

4.3.2 Theorem (Superposition Principle). Let D and B be linear dierential operators. If f1 , f2 , , fk satisfy the linear partial dierential equations D(fi ) = 0 and the boundary conditions B(fi ) = 0 for
2

If the underlying price keeps below the barrier through out the options life time.

Section 4.3. Static Hedging

Page 22

i = 1, 2, 3, , k and if c1 , c2 , c3 , , ck are arbitrary constants, then f = c1 f1 +c2 f2 +c3 f3 + +ck fk satises D(f ) = 0 and B(f ) = 0. This is the so-called superposition principle. (Lotter 2004). Now suppose a target option V which satises the Black-Scholes PDE given some boundary conditions. Any static portfolio comprising of a linear combination of shares and vanilla options also satises Black-Scholes PDE since the PDE is linear under superposition. If the components of are in such proportions that satises the Black-Scholes PDE under the same boundary conditions as V , then by the uniqueness of solutions to the boundary value problem, V = . As an example, for an up-and-out call option, the Black-Scholes PDE has the following boundary conditions, C(0, t, K, T ) = 0; C(S, T, K, T ) = (S K) ; C(B, t, K, T ) = 0;
+

S>0 for all t T.

tT

(4.3.1)

Now let us assume we have a portfolio (St , t) containing call options Ci (St , t, Ki , i ) of dierent maturities and strike prices with corresponding weight of i , where the following conditions hold: (ST , T ) = (ST K)+ ; (0, t) = 0 (B, tj ) = 0 ST < B (tj < j < T ), j = 1, 2, , n 1. tT (4.3.2)

It follows from the superposition principle that D() = 0, since D(Ci (St , t, Ki , i )) = 0 for i = 1, 2, 3, , n 1. By the uniqueness of the solution to the boundary problem, we observe that increasing the number of points (tj ) at which our portfolio (St , t) matches with the option value at the boundary, the portfolio value tends to the value of the up-and-out barrier option for all t T and St B , therefore, matching the value along the boundary ensures that the option and the portfolio is the same at all times and underlying stock price. Therefore, (St , t) is the hedging or replication portfolio. 4.3.3 DEK-replication procedure. Consider a vanilla call option C(S, K, T, r, ) with one year to expiry. We wish to replicate an up and out barrier call option using a portfolio of this claim and a number of calls with dierent maturities (Calendar spreads), C(S, K, ti , mi , r, ) for i = 0, 1, 2, . Figure (4.2) shows two scenarios of evolution of the underlying stock price from the date of issuance t0 of the claim to its maturity T , namely, 1. The underlying price follows path 1 for S < B from t0 to T without hitting the barrier throughout the entire options life time. In this case the option holder receives an equivalent pay-o of a vanilla call option. 2. The underlying price takes path 2 whereby the barrier is hit at some time ti < T before maturity. At this instant, the claim is set worthless and the holder receives nothing. The graphs in gure 4.2 explain the reality of an up-and-out call option claim. However, a portfolio of C(S, K, T, r, ) will not posses a zero value at any instant a barrier is hit prior to maturity. Our target therefore, is to construct a portfolio of C(S, K, T, r, ) together with some more options which will behave exactly like the claim (up-and-out option). To achieve this, the hedger ought to know and

Section 4.3. Static Hedging

Page 23

Figure 4.2: Stock price evolution decide which position to take in a particular option and by what amount (weight of the option). We denote the weight of a particular hedge option Ci by i . Suppose at time t4 we have a portfolio that has value zero at the barrier at this instant containing the claim C(B, K, T, r, ) and 4 calls C(B, K4 , t4 , m4 , r, ) with expiry m4 . The value of this portfolio is 4 C(B, K4 , t4 , m4 , r, ) + C(B, K, t4 , T, r, ) = 0. However, at time t3 , the value of the portfolio will no longer be zero at the barrier 4 C(B, K4 , t3 , m4 , r, ) + C(B, K, t3 , T, r, ) = 0. This is because the underlying price changes with time and thus, the option value. To bring the value of this current portfolio to zero, we have to take an extra position in 3 calls with expiry at m3 generating a portfolio value of 3 C(B, K3 , t3 , m3 , r, ) + 4 C(B, K4 , t3 , m4 , r, ) + C(B, K, t3 , T, r, ) = 0. This portfolio replicates the claim at both t4 and t3 . At time t2 however, the value of this portfolio is dierent from zero. Similarly, we take another position of 2 calls with maturity m2 such that we obtain a zero value at t2 as well, 2 C(B, K2 , t2 , m2 , r, ) + 3 C(B, K3 , t2 , m3 , r, )+ 4 C(B, K, t2 , m4 , r, ) + C(B, K, t3 , T, r, ) = 0. (4.3.4) (4.3.3)

Continuing with the same argument, at time t0 (one year to expiry), we shall obtain a portfolio of value zero at the barrier as 0 C(B, K0 , t0 , m0 , r, ) + 1 C(B, K1 , t0 , m1 , r, ) + 2 C(B, K2 , t0 , m2 , r, )+ 3 C(B, K3 , t0 , m3 , r, ) + 4 C(B, K4 , t0 , m4 , r, ) + C(B, K, t0 , T, r, ) = 0. (4.3.5)

Section 4.3. Static Hedging

Page 24

This portfolio replicates our up-and-out barrier option at maturity T as well as at the barrier at times t0 , t1 , t2 , t3 and t4 . Between these times however, the portfolio fails to match with the claim at the barrier hence, a need for more positions in calls. Theoretically, there are innite points between ti and ti+1 so it is certainly clear that perfect static replication requires an innite number of options which in the actual sense is impossible. We do have a general idea about Dermans static replication. Now the task is to determine the weights i that satisfy equation (4.3.5). [DKE94] and [NP06] presented two but almost similar numerical methods for computing the i . From equation (4.3.3) we can obtain the rst 4 as 4 = C(B, K, t4 , T, r, ) . C(B, K4 , t4 , m4 , r, ) (4.3.6)

We observe from equation (4.3.6) that 4 is proportional to K4 , therefore choosing a smaller value of K4 will guarantee us a relatively smaller value of 4 . [DKE94] and [NP06] took the Ki s to be equal or above the barrier level for reasons already explained in the previous sections. Suppose Ki = B, the easiest way to compute the i s is to rewrite the above equations in form of a matrix as shown below, C(B, K, t4 , T ) C(B, K, t3 , T ) C(B, K, t2 , T ) = C(B, K, t1 , T ) C(B, K, t0 , T ) 0 0 0 0 C(B, B, t4 , m4 ) 0 0 0 0 C(B, B, t3 , m3 ) C(B, B, t3 , m4 ) 1 0 0 C(B, B, t2 , m2 ) C(B, B, t2 , m3 ) C(B, B, t2 , m4 ) 2 . 0 C(B, B, t1 , m1 ) C(B, B, t1 , m2 ) C(B, B, t1 , m3 ) C(B, B, t1 , m4 ) 3 C(B, B, t0 , m0 ) C(B, B, t0 , m1 ) C(B, B, t0 , m2 ) C(B, B, t0 , m3 ) C(B, B, t0 , m4 ) 4 (4.3.7) Since we already know the value of 4 from equation (4.3.6), we can easily compute the rest of the i s using the system in equation (4.3.7). Figure (4.3) shows some four cases of static replication. Panel (a) reects the value of a portfolio with two ordinary hedge calls and one call. The value of the portfolio at the barrier is zero when the remaining time to maturity is one year and also at a point when its six months. The portfolio exactly replicates the target option at the barrier only at these two points in this case. This means that if at all the underlying strike hit the barrier at any of these points, the portfolio value will be equivalent to the barrier option value. In panel (b) we added an extra call, thereby replicating the target option at three points prior to maturity. We observe a slight change in the rst loop, the values along this loop are close to the zero level. This gives a much better replication than in panel (a). Therefore, adding more options to the portfolio improves its accuracy in mimicking the target option. This is clearly seen in panel (d) in the rst six months where we almost have the exact behaviour of a barrier option at the barrier. For accuracy in static replication, the hedger has to take positions in a number of options with dierent (but rather too close to each other) maturities. This will try to cover up any instant the underlying strike hits the barrier. However, in reality, this is impossible since it calls for an innite number of options. This is one of the short comings of static replication.

Section 4.4. Hedging Performance/Error

Page 25

(a) Claim & 2 call options

(b) Claim & 3 call options

(c) Claim & 6 call options

(d) Claim & 12 call options

Figure 4.3: Dermans static replication 4.3.4 Carr-Chou-Static Hedging. Carr and Chou (1997) presented a dierent approach of static hedging to that of Derman et al. Unlike the DEK-strategy where the strikes of the hedging options are equal, Carr et al. considered a portfolio having options with dierent strikes and same maturity T of the barrier option whose payo value was adjusted (non-linear payo) to match that of the barrier option at the barrier and maturity. For detailed information refer to [CC97] and [Cho94].

4.4

Hedging Performance/Error

The hedging performance is dened as the ratio of the standard deviation of the cost of hedging an option to its Black-Scholes price [Hul93]. In perfect hedging, discounting the cost of hedging an option back to the beginning date of hedging should give a value equivalent to the Black-Scholes price of that option. Hence, the hedging performance of any replicating or hedging strategy also reects the hedging error. To get the general idea about the hedging error we consider a down-and-out call option using one of the static hedging strategies and the dynamic strategy.

Section 4.5. Further Work

Page 26

4.4.1 DEK - strategy. Suppose that at time t = 0 we sell o a down-and-out call at a price of DOT C(0) and in turn construct a hedging portfolio whose value is H(0). There are two scenarios that may occur from now to maturity; the barrier might be hit or not. If the barrier is not hit throughout the options life time, the hedging portfolio value is zero at maturity, T and the down-and-out call pays-o a value of (S(T ) K)+ . However, if the barrier is hit at time t < T , then we liquidate our portfolio for a value of H(t ) meanwhile, the value of the barrier option is worth DOT C(t ). Therefore, to obtain the hedging error, (t ) at t we compute the discounted error at t back to t = 0 assuming that the interest rate at t = 0 is r to obtain, DOT C(0) H(0) + ert (H(t ) DOT C(t )) (t ) = . DOT C(0)

(4.4.1)

4.4.2 Delta - strategy. In delta hedging, the hedging portfolio always undergoes rebalancing which accumulates costs at throughout the options life time. Thus, at time t , the accumulated costs will be worth, C(t ) and the hedging performance given as, DOT C(0) + ert (H(t ) C(t ) DOT C(t )) (t ) = . DOT C(0)

4.5

Further Work

The hedging portfolio may almost perfectly match the target option at the start but in future especially near hitting time there might be a mismatch. Therefore an optimization technique is required to reduce the losses that occur during hedging. In the previous section we observed that the hedging performance depends on a number of parameters such as, hitting time, the volatility, the risk-free interest rate and the price(s) of the option(s). More so, a particular hedging strategy has its specic parameters of consideration. The optimal hedging process or strategy ensures minimization of the losses of a particular hedging strategy with respect to some of its parameters of consideration [Dol06]. So we can nd these parameters which produce the best performance of the hedging strategy over all possible outcomes. Dolgavia [Dol06] presents a dierent approach of hedging the Vega-matching heging strategy which proves to be better than the delta- and static hedging strategies. It puts into consideration the fact that volatility is not constant, it does not rely on Black-Scholes assumptions. Stephane Crepey [Cre04] discusses another approach of hedging in his article entitled Delta-hedging Vega Risk. He compares the Prot and Loss arising from the delta-neutral dynamic hedging of options. He compares the Black-Scholes implied delta and the local delta. Besides the Black-Scholes model, many more models have been used to price and hedge barrier options in the world where volatility is not constant.

5. Conclusion
We have been able to obtain closed-form analytic solutions of options using the Black-Scholes model. Building on this model, more parameters can be introduced such as correlation between asset price and interest rates, jumps, volatility of volatility and other statistical estimates of the underlying process. [Tal96] The Black-Scholes model creates the possibility of replicating derivative securities under the risk-neutral relation in complete markets. We have been able to show that barrier options are cheaper than ordinary options. In fact, knock-out options become the the cheapest of all options with the same strike and maturity as we approach the barrier level. Even though barrier options are cheap and thus, attractive they are risky, since volatility is not constant and the barrier-hitting time is not predictable. We can price options precisely because we can hedge them, that is, we can hedge away the risk and for this matter, risk preferences dont play any role in option prices. Hedging barrier options minimise investors exposure to risk. The delta- hedging approach which uses shares and cash hedges well only if one could continuously rebalance the hedging portfolio. The challenge is that continuous hedging is impossible, we can only approximate it by hedging in discrete time with very small time rebalancing time steps. Another challenge is that this approach accumulates costs and hence it is expensive. Static hedging, a technique that uses options to hedge barrier options proves to be better than the dynamic approach. Using this technique, we construct the hedging portfolio once and for all at an initial time, no rebalancing required. However, the investor has to be on the watch such that S/he immediately liquidates the hedging portfolio at the barrier because this is the only time the barrier option will have the same value as the hedging portfolio. To improve static hedging, the hedger ought to use as many hedging options as possible, meaning that perfect hedging will require innitely many options. This will not be possible in real markets. However, static hedging gives a smaller hedge error and hedging costs compared to dynamic hedging.

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Appendix A. Barrier Option Prices


The following pricing formulae are reported from [Zha98]: A.0.1 Down-and-out call option. DOT C = C[S, max(B, K)]
B S
2 2

B2 S , max(B, K) B S
2 2

+ [max(B, K) K]er

N {d [S, max(B, K)]}

N d

B2 S , max(B, K)

(A.0.1) A.0.2 Down-and-out put option. This formula only exists if K > B otherwise its zero. DOT P = P (S, K) P (S, B) + (B K)er N (d [B, S]) P A.0.3 Up-and-out call option. UOT C = IB>K C(S, K) C(S, B) (B K)er N [d (S, B)] IB>K
B S
2 2 2

B S

2 2

B2 S

,K P

B2 S

, B + (B K)er N [d (B, S)]

(A.0.2)

B2 S ,K

B2 S ,B

(B K)er N [d (B, S)]

(A.0.3)

A.0.4 Up-and-out put option. UOT P = P [S, min(B, K)]


2 B 2/ S

B2 , min(B, K) [min(B, K) K]er S


2 B 2/ S

N {d [S, min(B, K)]} A.0.5 Down-and-in call option. DIN C =


B S
2 2

N d

B2 S , min(B, K)

(A.0.4)

B2 S , max(B, K)

+ P (S, K) P (S, B) + (B K)er N [d (S, B)] IB>K . A.0.6 Up-and-in call option . UIN C =
B S
2 2

+ [max(B, K) K]er N d

B2 S , max(B, K)

(A.0.5)

B2 S ,K

+ C [S, max(B, K)] + [max(B, K) K]er N {d [S, max(B, K)]} A.0.7 Down-and-in put option. DIN P =
B S
2 2

B2 S ,B

+ (B K)er N [d (B, S)] IB>K (A.0.6)

B2 S ,K

+ Pbs [S, min(B, K)] [min(B, K) K]er N {d [S, min(B, K)]} A.0.8 Up-and-in put option. UIN P =
B S
2 2

B2 S ,B

(B K)er N [d (B, S)] IK>B (A.0.7)

B2 S , min(B, K)

+ C(S, K) C(S, B) (B K)er N [d (S, B)] IK>B . 28

[min(B, K) K]er N d

B2 S , min(B, K)

(A.0.8)

Acknowledgements
Firstly, I give honour and praise to God Almighty for the gift of life and His continued blessings. I am heartily thankful to my supervisor, Peter Ouwehand, whose encouragement, supervision and support from the start to the nal level enabled me to develop an understanding of the subject. Special gratitude to Prof. Neil Turok, the founder of African Institute for Mathematical Sciences, and Prof. Barry Green, the director, who granted me the opportunity to pursue my studies this far. Great thanks to the entire AIMS administration especially Aeeda Mpofu, the administrative ocer and Jan Groenewald the IT manager, for the unconditional support and guidance they oered me from start to the end. I oer my regards and blessings to; Gordon Nana, Trust Chibawara, Frances Aron, Khalid Obeid, and the entire AIMS teaching sta who supported me in every respect during the completion of the essay. Lastly, I wish to express my love and gratitude to my beloved family and friends; for their understanding and endless love throughout the duration of my studies.

29

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