International Research Journal of Finance and Economics ISSN 1450-2887 Issue 35 (2010) EuroJournals Publishing, Inc. 2010 http://www.eurojournals.com/finance.

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The Pricing Model of Discrete Barrier Options

Yu-Cheng Lai Department of Finance, Shih Chien University Kaohsiung Campus, No. 200 University Rd Neimen Shiang, Kaohsiung 84500, Taiwan E-mail: br00846@yahoo.com Tel.: + 886 7 6678888; fax + 886 7 6679999 Kun-Chin Lee Department of Finance, Shih Chien University Kaohsiung Campus, No. 200 University Rd Neimen Shiang, Kaohsiung 84500, Taiwan E-mail: kclee@mail3.kh.usc.edu.tw Fu-Shine Peter Chou Institute of Information Management National Cheng Kung University 1 University Rd,Tainan City 701, Taiwan E-mail: fu-chou@mail.cju.edu.tw Pei-Jun Chen Institute of Information Management National Cheng Kung University 1 University Rd,Tainan City 701, Taiwan E-mail: em53100@email.ncku.edu.tw Abstract Barrier options are financial derivative contracts that are activated or extinguished when the price of the underlying asset crosses a certain level. Most models for pricing barrier options assume continuous monitoring of the barrier. However in practice most, if not all, barrier options traded in markets are discretely monitored. There are two problems when we discuss the discrete barrier option. First, when the barrier is discretely monitored, a numerical method may be used to value the option. However this method will increase calculation time exponentially with the numbers of barrier. Second, for discrete barrier option problems, the trinomial model is useful, but it is less effective when the barrier is very close to current asset price. In order to resolve these two problems, we propose an analytical methodology that satisfies the partial differential equation and initial condition that characterize the discrete barrier option problem. This method increases the calculation time linearly with the numbers of barrier. Moreover, the method is effective no matter what the asset price is. Furthermore, we also discuss the effect upon the choices of the numbers of partition and the integral interval.

Keywords: Discrete barrier options; Heat equation; Boundary integral method. JEL Classifications Codes: G12; G13; C63.

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1. Introduction
In the late 1980s and early 1990s, exotic options became more visible and popular in the over-thecounter (OTC) market. Their users were big corporations, financial institutions, fund managers, private bankers, and et cetera. The most popular group of exotic options is path-dependent options, and barrier option is among this group. Barrier options are also called trigger options, which become a regular option or get a rebate, depending on whether the barrier is breached during the life of the option. The barrier options are essentially conditional options, dependent on whether some barriers or triggers are breached within the lives of the options. They are therefore path-dependent. Barriers may be monitored continuously or discretely. Continuous monitoring of the barrier means that the barrier is effect at any time prior to maturity. This means that the barrier condition applies whenever the barrier is reached during the life of the option. Discrete monitoring implies that the barrier is in effect only at discrete times, such as daily or weekly intervals. In other words, the barrier condition applies only when the barrier is reached at the specified times, but not at other times. Most models for pricing barrier options assume continuous monitoring of the barrier; under this assumption, the option can often be priced in closed form. The price of a discrete barrier option can be expressed in closed form in terms of multivariate normal probabilities. The closed-form formula with the discrete barrier option will involve an n-variate cumulative normal distribution if the barrier is monitored n times ( Heynen and Kat, 1996). Since the multivariate cumulative normal density function in the analytical solution cannot be expressed as an elementary function, it can only be evaluated by a numerical approximation, which becomes either computationally intensive or produce less accurate estimations as dimension increases. The approximation methods could be used, such as standard lattice techniques. They obtain the correct valuation asymptotically, but for discrete barrier options, convergence may be slow and erratic, producing great errors even with thousands of time steps and millions of node calculations. The reason is that the payoff of a barrier option is very sensitive to the position of the barrier in the lattice. Boyle and Lau (1994) in their study of continuous barrier options discover that potentially large pricing errors can result from a lattice, even with a large number of steps. Ritchken (1996) develop a trinomial method, which adapts Boyles (1988) trinomial lattice by utilizing a stretch parameter. Ritchken (1996) points out that his approach is less effective when the barrier is very close to the current asset price. Figlewski and Gao (1999) provides a approach that greatly increases the efficiency in lattice models. However, the partial barrier options are monitored only at some specific time period, thus, it creates additional difficulty for modified lattice models to price partial barrier options. Therefore, building a lattice that deals effectively with discrete barriers is problematic. It has paid much attention to analytic solutions than to lattice methods. Heynen and Kat (1994, 1996), Carr (1995), Armstrong (2001) and Hull (2002) develop the closed-form solutions for the price of various types of barrier options. However, the convergence of the closed-form solutions is slow, and the results tend to have a large bias when the asset price is close to the barrier. Besides the close-to-barrier problem, it is known that barrier option price with continuous monitoring can be significantly different from those with discrete monitoring. Cheuk and Vorst (1996) show that even hourly versus continuous monitoring can make a significant difference in option value. Chance (1994), Flesaker (1991), and Kat and Verdonk (1995), indicate that there can be great pricing errors between discrete and continuous barrier options, even under daily monitoring of the barrier. Broadie, Glasserman, and Kou (1997) discover a correction procedure. Their approach produces very accurate prices, as long as the barrier is not close to the underlying asset price. Gao (1996) proposed an adaptive mesh method, which overcomes some of the problems posed by the above models. Even with this modification, the computational time increases, as the current underlying asset price gets closer to the barrier. Further, Wei (1998) proposes an interpolation method between the formula for a barrier option with the highest number of monitoring points that can be handled with the analytic formula and the continuous case. In parallel with the determination of these pricing formulas, numerical methods have been used for pricing barrier options, especially in those cases where analytical pricing solutions remain unavailable, such as for discrete barrier options ( Braodie et al.,

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1997; Bertoli and Bianchetti, 2003; Duan et al., 2003; Fusai et al., 2006; Skaug and Naess, 2007; Ndogmo, 2008). The following are the two difficulties. Firstly, when the barrier is discretely monitored, a numerical method may be used to value the option. However this method will increase calculation time exponentially with the numbers of barrier. Secondly, pricing is less effective and erratic when the barrier is very close to the current asset price. Aiming to resolve these two problems, we propose an analytical methodology that satisfies the partial differential equation and initial condition that characterize the discrete barrier option problem. This method increases the calculation time linearly with the numbers of barrier. Moreover, the method is effective no matter what the asset price is. The paper is organized as follows. In Section 2, we propose the methodology and an alternative pricing model. Section 3 discusses the model performance. Section 4 concludes the paper.

2. The PDE Model

In this section, a partial differential equation (P.D.E.) approach is proposed to ease the computational intensity in the first section of this chapter. Finally, the P.D.E. methodology is applied to evaluate the discrete barrier options. 2.1. The Black-Scholes Partial Differential Equation In this section, we describe the Black-Scholes partial differential equation which is abstracted from Ritchken (1987), assuming that the return on the stock follows a diffusion process as described by the following stochastic differential equation: dS = dt + dZ (1) S where S is the underlying stock price, is the drift on the stock per unit time, 2 is the variance of the return on the stock per unit time and dZ is a mean zero normal random variable with dt , or a standard Gauss-Weiner process. This process for stock prices is also known as the Geometric Brownian motion. Under the Black-Scholes assumptions, two duplicate portfolios must earn the same equilibrium rate of return. Thus, under the no arbitrage condition, the value of the discrete barrier option can be defined by the famous Black-Scholes partial differential equation:

2 This non-stochastic equation under the initial condition is as follows: S E , ST > E C(S, T ) = T 0, S T < E And the solution of this partial differential equation is the Black-Scholes formula. 2.2. Transform Black-Scholes Partial Differential Equation to Heat Equation

S 2 C SS + r f SC S Crf + Ct = 0

(2)

(3)

In this section, we describe the process that transforms the Black-Scholes partial differential equation to heat equation. The Black-Scholes partial differential equation, which depicts the behavior of the option price, is forward type. However, the forward type equation will be ill-post problem. We need to change the forward type into backward type, and then the equation will become well-post problem in evaluation process. The original Black-Scholes partial differential equation is as follows:

2
2

S 2 C SS + r f SC S + Ct = Crf

(4)

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For the above-mentioned reason, let the new variable t * = T t , which means the time to maturity. Moreover, let the other new variable x be ln S + t * . Then, we can derive the following equation:

+ Crf = Crf (5) 2 2 Under the risk-neutrality environment, the equilibrium rate of the return to all assets should be equal to r f ; the stock price S follows the standard diffusion process:
* C xx e

rf t*

+ ( rf

* )C x e

rf t*

Ct** e

rf t*

dS = ' dt + dZ S
where ' = r f

(6)

and r f is continuous compounded riskless interest rate. Therefore, Equation (5) 2 can be rewritten as the following equation; the heat transfer equation in its simplest form:

2
2

* C xx = Ct**

(7)

2.3. Heat Equation and Initial Value Problem The heat equation is rewritten as the following two equations:

2
2
* t*

* C xx ( x, t * ) = Ct** ( x, t * ) *

(8)

(9) 2 As we mentioned above, t * means the time to maturity. Therefore, if T denotes the expiration date, then t * = 0 . Define: Initial condition: C ( x, 0) = C0 ( x ) (10)

C ( x, t )

* C xx ( x, t * ) = 0

Initial value = C0 ( x ) (11) In the following section, we will introduce a partial differential equation (P.D.E.) valuation method to solve the initial problem.

3. The Methodology
In this section, we introduce the methodology to solve the pricing problem. It contains three parts. First part shows the process of solving the initial value problem by boundary integral method. Second part introduces the instruments of numerical integral. Third part depicts the pricing. The final part discusses the evaluation process.
3.1. Boundary integral method

Since the principle part is the discrete barrier option, the partial differential equation is only composed of initial condition. The initial value problem can be represented as follows: 2 I.C.: C ( x, 0) = C0 ( x ) P.D.E.: Ct** ( x, t * )

* C xx ( x, t * ) = 0

(12) (13)

First of all, we denominate G ( x, t ; , t ) is the fundamental solution of Equation (12), given by G ( x, t * ; , t )

*

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= 1 2 2 (t * t )

International Research Journal of Finance and Economics - Issue 35 (2010)

exp( (x ) 2 ) H (t * t ) 2 * 2 (t t ) (14)

t * t 0, H (t * t ) = 1 where H (t * t ) is the Heaviside function, when * . Next, Equation (12) is * < 0 , ( ) = 0 t t H t t multiplied by G and deals with double integral. We can derive the following equations:

(Ct**

2
2

* C xx )Gdxdt * = 0

(15)

(16) 2 The double integral procedure contains two parts. The first part of Equation (16) becomes the following equation:
0
0

Ct** Gdt * dx

* C xx Gdxdt * = 0

C Gdt dx = C ( x, 0)G ( x, t ; , 0)dx

0 * t* *

CGt * dxdt *

(17)

The second part of Equation (16) becomes the following equation:

* 0 2 CGxx dt dx 2 Now we combine Equation (17) and (18), we get 0 * C xx Gdxdt * =

(18)

C ( x, 0)G ( x, t ; , 0)dx
*

C (Gt * +

2
2

G xx )dxdt * = 0

(19)

Define: (20) 2 where C ( x, t * ) is the expected value of the call when stock price = S and time to maturity = t * , i.e. the expected value of the call at expiration date. In addition, x is equivalent to ln S + t * . Then, Equation (20) can be rewritten as follows:
0

C (Gt* +

Gxx )dxdt * = C ( x, t * )

C ( x, t * ) = C ( x, 0)G ( x, t * ; , 0)dx

(21)

= C0 ( x)G ( x, t * ; , 0)dx

(22)

Equation (22) is an integral presentation for C ( x, t * ) where G is the fundamental solution of the heat equation.
3.2. Numerical integral

There are two methods to do numerical integral; one is Simpsons Rule and the approximate equation of the cumulative normal distribution function, which contains the Complementary Error Function.
Simpsons Rule

(b a ) a+b f (a ) + 4 f ( ) + f ( b) a 6 2 We divide [a, b] into n equal parts and n are an even ba xi = a + ih, h = , (0 i n ) , then Equation (23) can be rewritten as follows: n

f ( x )dx

(23) number. Let

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41 (24) (25)

f ( x )dx = f ( x )dx + f ( x )dx + +

x0 x2

x2

x4

x2 i

x2 i 2

f ( x )dx

=
i =1

n/2

x2 i

x2 i 2

f ( x )dx

h n/2 (26) [ f ( x2i2 ) + 4 f ( x2i 1 ) + f ( x2i )] 3 i =1 The approximate equation of cumulative normal distribution function We use the Complementary Error Function to estimate the value of the cumulative normal distribution function. The definition of the Complementary Error Function is as follows: 2 2 erfc( x ) = (27) exp( u )du

By means of expansion, we get the following equation with respect to the cumulative normal distribution function: 1 x N ( x ) = ( erfc( ) + 1) (28) 2 2
3.3. The pricing

We consider a European down-sand-out call option with two discrete barriers as an example. The first and second barrier dates are 1 and 2 . The constant barrier level is B . Integration (22) can be more tractable mathematically by transforming lognormal density function into normal density function, i.e. setting x = ln S + t . Thus, we transform some notations as follows: x = ln S + t x E = ln E + 0 2 b1 = ln B + 1 b2 = ln B + 2
Exhibit 1: The First Pricing Map

= rf

Call price B D F H

Region

Region

G Time

Current time

First barrier date

Second barrier date

Expiration date

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Exhibit 1 depicts the first pricing map. We define the time interval between the expiration date and the second barrier date as Region , and that between the first barrier date and the second barrier date as Region . Line GH is the call price of the discrete barrier option at the expiration date. Line
CD and line EF are the call prices of the discrete barrier option on the first and second barrier dates. Similarly, line AB is the call price of the discrete barrier option at current time. The call prices can be calculated by the Black-Scholes formula at the expiration date i.e. line GH . Thus, line GH is the initial condition for Region . By means of the recursive P.D.E. method, we

can get the call price on line EF . For Region , line EF becomes the initial condition. Using the recursive P.D.E. method again, we can get the call price on line CD . The following section describes the difficulty of pricing which arises in the evaluation process. Exhibit 2 shows the difficulty of pricing. We posit the value of M is a constant. We use the call prices between the following interval: [ b1 , ( x + M ) ] to obtain the call price at current time. Next we need to use the call prices between the following interval: [ b2 , ( x + 2 M ) ] to obtain the call price at the logarithmic stock price equivalent to ( x + M ) . Similarly, we need to use the call prices between the following interval: [ x E , ( x E + 3M ) ] to get the call price at the logarithmic stock price equivalent to ( x + 2 M ) . One major difficulty arises in the valuation process. The integral interval will become broader and broader since the numbers of barrier increase.
Exhibit 2: The Difficulty of Pricing Map

x +3M x +2M

x +M

x
b1 b2 xE

Current time

First barrier date

Second barrier date

Expiration date

In order to solve this problem, we propose an alternative evaluation method. Exhibit 3 shows the second pricing map. Applying the property of the normal distribution, we know the probability that x falls between ( 3 * ) and ( + 3 * ) is 0.9974 where is the mean and * is the standard deviation of the normal distribution. Therefore, the probability that x falls between ( 4 * ) and ( + 4 * ) is nearly equivalent to 1. In finance, the standard deviation is referred to as the volatility. Since we want the probability that (b1 + M ) hits the barrier b2 is very small, we set the M be a constant and equivalent to 4 1 2 . As we know that the volatility expands with the square root of

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43

the time period. Hence, if the volatility is per year, the volatility over a period of t years is t . Here we let 1 21 represent t . The different barrier dates and volatility will decide the different values of M . Further, we add another equal interval to do numerical integration because of accuracy. This alternative method solves the problem of the broader of the integral interval.
Exhibit 3: The Second Pricing Map

b1 + 2 M

b2 + 2M

xE + 2M

b1 + M

b2 + M

x
b1

b2

xE

t
Current time

1
First barrier date

2
Second barrier date

0
Expiration date

We define the integral intervals [ b1 , (b1 + M ) ] and [ b2 , (b2 + M ) ] as the complex areas. Similarly, we postulate the intervals [ x E , ( x E + 2 M ) ], [ (b1 + M ) , (b1 + 2 M ) ] and [ (b2 + M ) , (b2 + 2 M ) ] as the simple areas. Then, we divide each interval: [ b1 , (b1 + 2 M ) ], [ b2 , (b2 + 2 M ) ] and [ x E , ( x E + 2 M ) ] into 2n equal parts. Obviously, the price of the discrete barrier option is zero when the stock price hits the barrier.
3.4. Evaluation Process

There are two methods for the evaluation process of the discrete barrier option:
Evaluated by the simple areas In the interval [ x E , ( x E + 2 M ) ], the option price can be obtained by the Black-Scholes formula and Equation (28). Since in the other two intervals [ (b1 + M ) , (b1 + 2 M ) ] and [ (b2 + M ) , (b2 + 2 M ) ], the probability of hitting the barrier is very small, we can also apply the Black-Scholes formula and Equation (26) to evaluate the call option price. Evaluated by the complex areas First, we recall Equation (22), and posit C0 ( x)G ( x, t * ; , t ) as f ( x ) . Then applying Equation (26), we can evaluate the call option price. Integration may be easily evaluated by Simpsons rule, because the kernel G is smooth. But the options price we get is the expected value of the option at expiration date. We should

discount the expected terminal value to the current time by multiplying e

rf t*

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4. Results for One-Year Maturity

This section presents the calculation results by means of the recursive P.D.E. method. First, we consider pricing a single European down-and-out call option. Second, we explore some pricing error relationships that exist between the partition of the integral interval and the use of the Black-Scholes formula. The option parameters are as follows:2 Stock price: S = 40 E = 40 Strike price: Maturity: T = 1 year Riskless interest rate: rf = 0.05 Volatility: Dividend yield: Barrier level: Rebate at barrier: Barrier date:

= 0.4 q= 0 B = 35 Rb = 0 = 0.5 year

C We define True value as the true value of the single discrete barrier call and C PDE as the call price of the pricing model. For an option with one single discrete barrier, the true value we get is equal to 6.872549. It obtains from the numerical approximation of cumulative normal distribution function. We let the value of M = 4 * 0.4 * 0.5 = 1.131371, i.e. four standard deviations. 0.5 is the time period and
we divide the integral interval into 2150 equal parts. 3 Then we obtain the value of C PDE = 6.871389. C The call value in this case is very accurate comparing to the true value. Compare True value with C PDE , we detect some relationships. Thus, we define the absolute and relative pricing errors as C PDE CTrue value C /C 1 , respectively. and PDE True value Exhibit 4 shows the price results for different values of M and different numbers of partition. We also show the absolute and relative pricing errors respectively in Exhibit 4. Exhibit 5 depicts the paths of the call prices for different units of the standard deviation. Exhibit 6 and 7 also illustrate the paths of the absolute and relative pricing errors for different units of the standard deviation. We describe some relationships from Exhibit 5. When the value of M is equal to three standard deviations, i.e. 0.848528, the call price is the highest. However the call prices decrease as the value of M increases from four standard deviations to ten standard deviations, i.e. from 1.131371 to 2.828427. Based on the Exhibit 5, we can detect a trend of the call prices. The paths of the call prices become smoother as the value of M increases. This phenomenon is especially remarkable when the numbers of partition increase from 500 to 2000. We describe some relationships from Exhibit 6 and 7. When the value of M is equal to three standard deviations, i.e. 0.848528, the absolute pricing error is the lowest. However the absolute pricing errors increase as the value of M increases form four standard deviations to ten standard deviations, i.e. from 1.131371 to 2.828427. The paths of the absolute and relative pricing errors also become smoother as the value of M increases in Exhibit 6 and 7. This phenomenon is especially remarkable for the numbers of partition increase form 500 to 2000.

2 3

In this section, there are two examples are extracted from Ahn, Figlewski and Gao [1999]. Due to the limit of memory, 2150 is the most parts we can divide.

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Exhibit 4: Down-and-Out Call Option Price Results, One Barrier
Numbers of partition

45

M value ( ) M value
2 3 4 5 6 7 8 9 10 M value ( ) 2 3 4 5 6 7 8 9 10 M value ( ) 2 3 4 5 6 7 8 9 10 0.565685 0.848528 1.131371 1.414214 1.694056 1.979899 2.262742 2.545584 2.828427

C PDE
6.864880 6.868795 6.867630 6.866462 6.865305 6.864126 6.862959 6.861793 6.860625

Absolute pricing error 0.007669 0.003754 0.004919 0.006087 0.007244 0.008423 0.009590 0.010756 0.011924 Absolute pricing error 0.006375 0.001880 0.002465 0.003049 0.003635 0.004213 0.004798 0.005384 0.005967 Absolute pricing error 0.005733 0.000947 0.001246 0.001537 0.001826 0.002118 0.002408 0.002699 0.002988

Relative pricing error 0.001115889 0.000545795 0.000715746 0.000885698 0.001054049 0.001225601 0.001395407 0.001565067 0.001735019 Relative pricing error 0.00092760 0.00027355 0.00035867 0.00044365 0.00052892 0.00061302 0.00069814 0.00078341 0.00086824 Relative pricing error 0.000834188 0.000137795 0.000181301 0.000223643 0.000265695 0.000308183 0.000350379 0.000392722 0.000434773

500

Numbers of partition

M value
0.565685 0.848528 1.131371 1.414214 1.694056 1.979899 2.262742 2.545584 2.828427

C PDE
6.866174 6.870669 6.870084 6.869500 6.868914 6.868336 6.867751 6.867165 6.866582

1000

Numbers of partition

M value
0.565685 0.848528 1.131371 1.414214 1.694056 1.979899 2.262742 2.545584 2.828427

C PDE
6.866816 6.871602 6.871303 6.871012 6.870723 6.870431 6.870141 6.869850 6.869561

2000

The difference in M is 0.4 * 0.5 = 0.282843, i.e. one standard deviation expands with the square root of the time period equivalent to 0.5.
Exhibit 5: The Paths of Call Prices for Different Units of Standard Deviation

6.875

Call price

6.87 6.865 6.86 2 3 4 5 6 7 8 9 10

Numbers of partition = 500 Numbers of partition = 1000 Numbers of partition = 2000

Units of standard deviation, M value

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Exhibit 6: The Paths of Absolute Pricing Errors for Different Units of Standard Deviation

0.015

Pricing error

0.01 0.005 0 2 3 4 5 6 7 8 9 10

Numbers of partition = 500 Numbers of partition = 1000 Numbers of partition = 2000

Units of standard deviation, M value

Exhibit 7: The Paths of Relative Pricing Errors for Different Units of Standard Deviation

0.002

Pricing error

0.0015 0.001 0.0005 0 2 3 4 5 6 7 8 9 10

Numbers of partition = 500 Numbers of partition = 1000 Numbers of partition = 2000

Units of standard deviation, M value

In order to verify our pricing results, we can use the price of the continuous barrier option for the same parameters to examine the performance of our pricing approach. 1Further, we also compute the pricing results of the discrete barrier options for the same maturity, but different barrier dates using our pricing approach; that is, besides the different barrier dates, the other option parameters are the same. Exhibit 8 shows the price results of the above barrier options.
Exhibit 8: Down-and-Out Call Option Price Results, Different Monitoring Frequencies
Numbers of partition Monitoring frequency Annually Semi-annually Quarterly Monthly Weekly Daily Hourly Continuous

M value
1.131371 1.131371 1.460593 1.568929 1.593834 1.599744

C PDE
7.209181 6.871389 6.425951 5.785302 5.226683 4.882504 4.629461 4.581653

2150

The price of the continuous barrier option is 4.581653. We study five discrete barrier options with quarterly, monthly, weekly, daily, and hourly monitoring. The prices of the discrete barrier options are 6.425951, 5.785302, 5.226683, 4.882504, and 4.629461 respectively. Similarly, the values of M are 1.131371, 1.460593, 1.568929, 1.593834, and 1.599744. The integral interval is also divided
1

The continuous barrier option price is obtained from the software of OPTION! written by Kolb [1999].

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47

into 2150 equal parts. Moreover, the Black-Scholes formula corresponds to a barrier option with only one monitoring at maturity, i.e. annually monitoring. In this case, the barrier level is 40 and the call price is 7.209181. Exhibit 9 shows the price results of the above discrete barrier options. For these five options, the monitoring frequencies are 4, 12, 52, 260, and 6240, which correspond to quarterly, monthly, weekly, daily, and hourly monitoring. The monitoring frequencies include the last monitoring at maturity. As noted before, the formula will involve an n-variate cumulative normal distribution if the barrier is monitored n times (Heynen and Kat, 1996). In addition, Ahn, Figlewski and Gao (1999) also mentioned that it is difficult to compute reliable estimates for the multivariate normal distribution once the dimension is greater than about four. Nevertheless our pricing approach can handle the condition of the monitoring frequencies more than four times and reach 6240.
Exhibit 9: The Paths of Call Prices for the Continuous and Discrete Barrier Options

Call price

6.5 6 5.5 5 4.5 4

Semiannually Quarterly Monthly Weekly Daily Hourly Discrete barrier option Continuous barrier option

Monitoring frequency
Moreover, the price results shown in Exhibit 9, which converge to the price of the continuous barrier option. These results imply that, for the same parameters, our pricing is considerably accurate. Since we know that the price of the continuous barrier option is relatively lower than the price of the discrete one, our pricing is theoretical correct. There are two causes of pricing errors in this example. The first cause stems from the numbers of partition in the integral interval. This pricing error reduces rapidly as the numbers of partition increases. The second cause comes from the use of the Black-Scholes formula. Exhibit 4 shows the absolute pricing errors for different values of M and different numbers of partition. In light of the observation in Exhibit 4, we explore some pricing error relationships that exist between the partition of the integral interval and the use of the Black-Scholes formula. First, when the numbers of partition are the same, the absolute and relative pricing errors decrease when the value of M increases from two standard deviations to three standard deviations. However, these two pricing errors increase as the value of M increases from three standard deviations to ten standard deviations. The reason is the interval between two divided points become broader. Due to the broader of the interval, these two pricing errors may increase as the value of M increases. Moreover we may indicate that the integral interval we choose is a little broader, that is, four standard deviations. The set of M may be more appropriate for three standard deviations. Second, we have seen that there are two pricing errors in the pricing process. In light of the observation in Exhibit 4, we detect that the majority of pricing errors remarkably comes from the first cause, i.e. the numbers of partition in the integral interval. Exhibit 10 presents the pricing errors as the numbers of partition increase for the value of M equivalent to four and eight standard deviations.

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As shown in the first panel of Exhibit 10, i.e. M = 1.131371, the absolute pricing error decreases from 0.004919 to 0.002465 by increasing the numbers of partition from 500 to 1000. The relative pricing error also decreases from 0.000715746 to 0.000358670. The phenomenon is also similar for the numbers of partition increase from 1000 to 2000. While the numbers of partition double, the absolute and relative pricing errors will become a half of origin. Hence, we can indicate that the numbers of partition dominate the absolute and relative pricing errors. The impact of using the BlackScholes formula is extremely trivial.
Exhibit 10: Absolute and Relative Pricing Errors, Varying Numbers of Partition and M Value

C PDE Absolute pricing error Relative pricing error Numbers of partition 500 6.867630 0.004919 0.000715746 1.131371 (4 ) 1000 6.870084 0.002465 0.000358670 2000 6.871303 0.001246 0.000181301 500 6.862959 0.009590 0.001395407 2.262742 (8 ) 1000 6.867751 0.004798 0.000698140 2000 6.870141 0.002408 0.000350379 Option parameters: S = 40, E = 40, T = 1 year, r f = 0.05, = 0.4, B = 35, and = 0.5 year. The M value: 1.131371 =

M value

4*0.4* 0.5 , and 2.262742 = 8*0.4* 0.5

Third, given the same interval of the partition, the absolute and relative pricing errors are almost equivalent. For example, the absolute pricing error equals 0.002465 with 1000 partitions and for M = 1.131371 and the other absolute pricing error equals 0.002408 with 2000 partitions and for M = 2.262742. These two pricing errors are fairly approximate. Furthermore, the relative pricing error is 0.000358670 for M = 4 and the numbers of partition are 1000. It makes no difference to the relative pricing error is 0.000350379 for M = 8 and the numbers of partition are 2000.

5. Conclusion
Exotic options are now widely used in global financial markets such as barrier options. Their popularity calls for the development of faster and more stable numerical methods. In general, a closedform valuation equation exists only in European options with a continuous barrier. For discrete barrier options, some difficulties arise in the pricing process. The majority of valuation methods are based on a lattice or other correction methods, which are limited to handle this feature. In this thesis, we develop an alternative evaluation model to solve the problem. In this section, we draw some conclusions from our pricing process as follows: When the numbers of partition are the same, the absolute and relative pricing errors increase as the value of M increases. The majority of pricing errors remarkably comes from the numbers of partition in the integral interval. The absolute and relative pricing errors have similar moving paths when the value of M increases in multiple. From the continuity test, we detect that our pricing results are quite smooth at each partition point. It means that the integral interval we choose is appropriate. The pricing model has several advantages over the current approaches. Firstly, it has great flexibility in every kind of the barriers that can be handled. Secondly, it can get up to a high accuracy by using more numbers of partition in the integral interval. Thirdly, the methodology possesses two properties of increasing the calculation time linearly with the numbers of barrier and the evaluation is no difference no matter what the underlying asset price is.

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