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Antoon Pelsser - Pricing double barrier options using Laplace transforms.pdf

Antoon Pelsser - Pricing double barrier options using Laplace transforms.pdf

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Published by Chun Ming Jeffy Tam
Antoon Pelsser - Pricing double barrier options using Laplace transforms.pdf
Antoon Pelsser - Pricing double barrier options using Laplace transforms.pdf

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Finance Stochast. 4, 95–104 (2000)c
 Springer-Verlag 2000
Pricing double barrier options using Laplacetransforms
Antoon Pelsser
1
,
2
1 ABN-Amro Bank, Structured Products Group (AA 4410), P.O.Box 283 1000 EA Amsterdam, TheNetherlands( Tel: (31)20–628 7028, Fax: (31)20–691 1705)2 Erasmus University Rotterdam, Department of Finance, P.O. Box 1738, 3000 DR Rotterdam, TheNetherlands (e-mail: pelsser@few.eur.nl)
Abstract.
 In this paper we address the pricing of double barrier options. Toderive the density function of the first-hit times of the barriers, we analyticallyinvert the Laplace transform by contour integration. With these barrier densities,we derive pricing formulæ for new types of barrier options: knock-out barrieroptions which pay a rebate when either one of the barriers is hit. Furthermore wediscuss more complicated types of barrier options like double knock-in options.
Key words:
 Option pricing, Laplace transform, contour integration
JEL classification:
G13
Mathematics Subject Classification (1991):
 44A10,35K05
The author would like to thank Dieter Sondermann, two anonymous referees, participants of the 1997French Finance Association Conference in Grenoble and of the Third International Conference onComputation in Economics and Finance in Stanford for their comments and suggestions.
Editor’s note:
Different solution methods for pricing double barrier options have already been proposed in theliterature (see e.g. Kunitomo-Ikeda 1992, German-Yor 1996 and the following comment by Hui etal.). Nevertheless we decided to publish Pelsser’s paper, since his method to use contour integrationin the complex plane for Laplace transform inversion is different and may be of independent interestfor related problems in finance. In a letter to the Editor Michael Schr¨oder (University of Mannheim,Lehrstuhl Mathematik III) pointed out certain difficulties when applying this method uncritically inother contexts, in particular in choosing the integration path and checking the condition of Cauchy’sResidue Theorem.Manuscript received: August 1997; final version received: October 1998
 
96 A. Pelsser
1 Introduction
Barrier options have become very popular instruments in derivative markets. It isrelatively straightforward to price and hedge ”single barrier” options. Valuationformulas have been available in the literature for quite a while, see Merton (1973)or Goldman et al. (1979). The valuation and hedging formulas have been incor-porated in standard market software for options traders and clients. In fact, mostderivatives firms view ”single barrier” options nowadays more like vanilla thanexotic options.One of the reasons why barrier options have become so popular, is the factthat they are cheaper than standard options, but offer a similar kind of protec-tion. A natural extension to ”single barrier” options is to consider double barrieroptions. These are options which have a barrier above and below the price of the underlying, and the option gets knocked in or out as soon as one of the twobarriers is hit.Several papers have already analysed double knock-out call and put optionsusing different methods. Kunitomo and Ikeda (1992) derive the probability den-sity for staying between two (exponentially) curved boundaries. They express thedensity as an infinite sum of normal density functions, and the prices for doubleknock-out calls and puts are derived by integrating with respect to this density.In a recent paper, Geman and Yor (1996) derive expressions for the Laplacetransform of the double barrier option price. They invert the Laplace transformnumerically to obtain option prices.These papers deal, however, with only one type of double barrier option:double barrier knock-out calls and puts. In the markets a much wider varietyof double barrier options is being traded. Especially, options which pay a fixedamount of money (a ”rebate”) as soon as one of the barriers is hit and doublebarrier knock-in options.The contribution of this paper is twofold:First, we analytically invert the Laplace transforms of the probability densityfunctions using contour integration. Option prices are then calculated by integrat-ing the option payoff with respect to the density functions. To our knowledge thisis one of the first applications of contour integration to the area of option pricingtheory. Although the same result can be derived by other methods, we believethat contour integration is a very powerful tool with many potential applicationsin finance.Second, we derive analytical formulas for pricing a wider variety of doublebarrier options than has been treated so far in the literature.
1
We find formulasfor options which give a constant payoff either ”at hit” or at maturity, we de-rive pricing formulas for double barrier options where the final payoff can be
1
In a recent paper, Sidenius (1998) also derives valuation formulæ for knock-out options withrebates and knock-in options. His approach is based on ”path counting” which is basically the methodof images. In another recent paper, Schr¨oder (1998) derives the Kunitomo-Ikeda (1992) valuationformulas by inversion of Laplace Transforms derived in Geman-Yor (1996).
 
Pricing double barrier options 97
expressed as any power of the underlying value and we find valuation formulasfor knock-in options.The paper is organised as follows. In Sect.2 we derive our analytical expres-sions for the probability density of the first passage time for the upper and lowerbarriers. In Sect.3 we derive some pricing formulas for different kinds of doublebarrier options. Finally, we conclude in Sect.4.
2 Barrier densities
If we make the assumption (which is standard) that the underlying asset of theoption can be modeled as a geometric Brownian motion, we can model the logof the asset price (under the equivalent martingale measure) by the followingstochastic differential equation
dz
 =
 µ
dt 
 +
 σ
 dW 
,
 (1)where
 µ
 and
 σ
 are constants.The case we want to consider is more complicated. We want to value doublebarrier options. This can be modeled by assuming that the process
 z
 is killedas soon as it hits one of the two barriers. Suppose we have two barriers, thelower barrier is located at 0, the upper barrier at the level
 l
. This specificationis general, since we can always shift the process
 z
 by a constant such that thelower barrier is placed at 0.Let us consider the transition density function
 p
(
,
 x
;
s
,
 y
). It describes the prob-ability density that the process
 z
 starts at time
 
 at
 z
(
) =
 x
 and survives untiltime
 s
 and ends up at
 z
(
s
) =
 y
. Of course we have,
 t 
 
s
 and 0
 x
,
 y
 
l
.The transition density function
 p
(
,
 x
;
s
,
 y
) can be represented in terms of aFourier series (see, e.g. Cox and Miller 1965):
 p
(
,
 x
;
s
,
 y
) =
 e
µσ
2
 (
 y
 x
)
2
l
=1
e
λ
(
s
)
sin(
π
 xl
)sin(
π
 yl
)
λ
 = 12
µ
2
σ
2
 +
 
2
π
2
σ
2
l
2
 .
(2)The choice for represention (2) has the additional advantage that analytical ex-pressions (on a term-by-term basis) can be found for calculating options prices.Hence, there is no need to work with approximations, as in the case of thecumulative normal distribution function.We have now characterised the density function of surviving until time
 s
.This densitiy is used for pricing double knock-out options which get nullified assoon as one of the barriers is hit.We are also interested in the density functions of hitting the upper and thelower barrier. These densities are used for pricing options which have a non-zeropayoff as soon as one of the barriers is hit.

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