# Stochastic Spring 2013, Lecture 3 Reading for this lecture: (1) [1] pp 10!

"11# (2) [2] pp 2#"31 (3) [3] pp \$#"\$%

Calculus,

&anilla 'arrier (ptions )n finance, a *arrier option is a t+pe of contract ,here option to e-ercise at .aturit+ depends on the underl+ing crossing or reaching a gi/en *arrier le/el 0here are se/eral t+pes of /anilla *arrier options (1/anilla2 stands for si.ple and li3uid on the .ar4et instru.ent) So.e 14noc4"out2 ,hen the underl+ing asset price crosses a *arrier (i e , the+ *eco.e ,orthless) )f the underl+ing asset price *egins *elo, the *arrier and .ust cross the *arrier a*o/e it to cause the 4noc4"out, the option is said to *e up"and"out 5 do,n"and" out option has the *arrier *elo, the initial asset price and 4noc4s out if the asset price falls *elo, the *arrier (ther options 14noc4"in2 at a *arrier (i e , pa+off 6ero unless the+ cross a *arrier) 7noc4"in options also fall in t,o categories: up"and"in and do,n"and"in 0he pa+off at e-piration is usuall+ a fi-ed a.ount, a call or a put 0here are also .ore co.plicated *arrier options, for instance, R)' (range in *ound) options ,hich for a specified financial inde-, for instance 3".onth Li*or rate or 2" +ear C8S rate, pa+s a fi-ed a.ount .ultiplied *+ the fraction of o*ser/ations ,hen the inde- is inside a specified range Later in this lecture ,e treat the si.plest case 9e price an up"and"out option ,hose pa+off at e-piration is a call and ,e assu.e that the stoc4 price is .od" elled *+ 'ro,nian .otion 5ssu.ption that the stoc4 price can *e .odelled *+ 'ro,nian .otion is rather unrealistic as 'ro,nian .otion (e/en ,ith large drift) can *e negati/e ,ith positi/e pro*a*ilit+ Later in the course ,e ,ill *e a*le to appl+ si.ilar calculations for the .ore realistic case ,hen the asset price follo,s a geo.etric 'ro,nian .otion Running .a-i.u. and first passage ti.e :or a stochastic process ;t,

t ≥ 0 ,e define (1)

the running .a-i.u. as

8t <

.a- ;s

0≤s≤t

is has continuous tra=ectories(in fact, ,e need onl+ ,ith pro*a*ilit+ one) Closel+ related to running .a-i.u. is the first passage ti.e ,hich is defined as 0a < inf{t > 0 : ;t < a}, (2) that is for
:or this process to *e ,ell defined ,e assu.e that the process ; t

a fi-ed a ti.e 0a is the first ti.e ,hen ;t reaches le/el a :ro. the
definitions it is clear that e/ents {0a ?

t} and {8t ≥ a} coincide, i e , , ∈ {0a ? t} ⇐⇒ , ∈ {8t > a} (3)

:ro. the e-a.ples in the *eginning of the lecture one can conclude that the /alue of .an+ *arrier options depends on the *eha/ior of the .a-i.u. asset price prior to option e-piration, or e3ui/alentl+, on the distri*ution of the running .a-i.u. :or instance, the 4no,ledge of the distri*ution of the running .a-i.u. (or e3ui/alentl+ of the first passage ti.e) is enough to co.pute the /alue of the si.ple 4noc4"in@out options
1

ultipl+ *+ 2 and notice that e/ent {'t > a) < 2 A(0a ? t) t}.ation2 a/aila*le at ti.a-i. 't > 9e .ent 't − '0a is nor.< and change a ta √ s 0hen d<− √ ta rt A(0a ? 2s 3@2 (#) t) < 0 2 √ 2 2Bs e 3 −a @2s ds. u ? 't ? /) < A(2a − / ? 't ? 2a − u) Since e/ents {0a ? t} and {8t > a} are e3ui/alent .e can easil+ sho. a} is a su*set of the e/ent {0a ? (%) E thus A(0a ? t) < 2A(0a ? t.u.ar4 3 0rul+ spea4ing.e ti. the independence of incre.e o*tain A(8t > a.otion . 2Bs 3 and thus the densit+ of 0a is Aroof 5ssu.t is a 'ro. 'ut it turns out that for a general stochastic process .hen stochastic process .s − '0 is a t independent of .a-i.hat happened *efore 0 8oreo/er.e follo.nian .t 0heore.al distri*ution is s+. 't > a) < 2A('t > a) − '0a is independent of F0a (1infor" .etric and pro*a*ilit+ of ' t *eing e3ual to a is 6ero (D) . and hitting ti.ents it ti. is rather co.2 the distri*ution of the running .e sthat ? t ':ro.e 'ro.. 1 Let u ? / ≤ a.ar4 2 'efore the start of the proof let us re. 1 (Reflection Arinciple ) Let a > 0 0hen A(0 a ? t) < 2A('t > a) Re.plicated and often cannot *e .ritten out in a closed for. let the inter/al (u.e /aria*les .rite the a*o/e e3uation as ∞ 2 r −.e can e-plicitl+ calculate the distri*ution of the running . so that − A(8t > (2t) (!) (\$) 1 2 a. u ? 't ? /) < A(2a − / ? 't ? 2a − u) A(0a ? Fo.u. then using the reflection principle . /) shrin4 to -.e o*tain A(0a ? t.all+ distri*uted Since a nor. the fact that 't (ne can go further and generali6e the result of 0heore.nian .otion 9e refer to [2] for the proof Re. 't < -) < A('t < 2a (10) -) < 2Bt √ e −(2a−-) @ . that t.otion )n the case .e that 't √ a e −a @2s 1 hits le/el propert+ a at so.nian .@ de A(0a ? t) < 2 (2t) √ 2Bt a √ (C) 0o find the pro*a*ilit+ densit+ of 0a . the incre.e 0 a) needs to *e pro/ed using the strong 8ar4o/ propert+ for 'ro.

't < -) √ 3 -) < @(2t) (11) 2Bt .e get the =oint densit+ 2 2(2a − −(2a−-) e A(8t < a.ith respect to a .Eifferentiating .

< 2Bt B √ −.− 7) e d.@2t √ 2Bt < r 7 7) e (.s of the cu.e use our 4no.@2 r √ 2B < d.− 2(2a − e−(2a− a?8 -) @(2t) 18t ?8 ('t − 7)H < 7)H -) √ 2Bt3 88 G √ < rr -) 7 8 - (.@2 ) e < 2 d- t e −7 @2t t r √ 7@ −e 2 −8 @2t r 7 8 e− 2 @ 2t -2 2B r 7 7 √ e − 2Bt t 8@ 2 √ t e−. the first ter.al distri*ution )ndeed. is a difference of the follo.e for si.ing t. t F t (1C) t .ar4 that @the sa.ledge of the =oint densit+ of 8t and 't gi/en *+ (11): 2 r r 1 dad(.otion Let us consider the option .ulati/e nor.ith stri4e 7 Let us assu.3 7noc4")n@(ut (ption on 'ro.al distri*ution .hich is 4noc4ed"out if *efore the e-piration ti.nian .− 7 r √ (.− 2Bt d- (13) 0he a*o/e difference could *e easil+ e-pressed in ter.ulati/e nor.plicit+ that the interest rate is e3ual to 6ero so that the /alue of the option is e3ual to G 18t ?8 ('t − 7)H (12) )n order to calculate the a*o/e e-pectation .here F (-) < Let us re.ethod applies for the case of general pa+off and 4noc4"out the pa+off is gi/en *+ of function f (-) and 4noc4"out condition condition is)fgi/en *+ 8tat ∈e-piration 5 then the /alue the option is ∞ ∞ 2 r r 2(2a − −(2a−-) @(2t) 1 e dad(1#) a∈ 5 √ -) f (-) 3 2Bt −6 −∞ e @2 [ 2 √ 2Bd6 is the cu.< F 7 √ 7@ 7 √ 8 − √7 .o integrals 8 2t -2 @ √ √ 8@ √ 2 t d.e t asset price crosses *arrier 8 0he pa+off at e-piration is a call .e .− 7) 2(2a − 2Bt 3 e −(2a−-) @ (2t) dad2 2 8 2 −(-−28 ) @2t −.

e :inall+.e using approach different fro.ords . solution for /anilla options is so i.e use the . .ericall+ Calculating deri/ati/es nu.a+ lead to unsta*le hedges .portant 0he reason is that the gree4s of the closed for.−∞ −∞ (ne has to co. for instance.pute the a*o/e integral nu.h+ ha/ing a closed for. *+ using 2E Si. let us co. solution could *e calculated anal+ticall+ .ise the gree4s are co.psonIs rule Let us sa+ a fe.hich is 3uite undesira*le ta4ing into consideration the transaction cost 0he first passage ti. the presented a*o/e )n particular.pute the distri*ution of the first passage ti. .hile other.artingale approach .ericall+.puted nu.ericall+ could *e /er+ nois+ and .

ation up to ti. 2 < 2F (a.artingale )ndeed.artingale propert+ at .ith infor. for s ? t J' G e t −J t@2 2 J(' |Fs < G e J' t −' 2 s )HJ' s t −J t@2 |Fs −' <e s s −J t@2 2 2 J(' G e e s ) |Fs (1D) (1%) J' −J t@2 J (t−s)@2 <e G3uation (1D) follo.easura*le in J"alge*ra Fs.s fro.ords.ent generating function of the first passage ti.o. /aria*le .ent 0a : G (K0a |F0) < K0.all+ distri*uted rando.s fro. . the independence of incre.e 0a Let us appl+ the . or in other .e s at +our disposal +ou 4no.o. J2) Geu.ith the proof that for an+ positi/e constant J stochastic process Kt < 2 eJ't −J2t@2 is a . 's G3uation (1%) follo.ents propert+ and the fact that for a nor. the fact that 's is . < 1 euaH 2 u J (1!) Let us use the fact that Kt is a .C Let us start .artingale to find the .e 0hus Ja−J 0 Changing /aria*le J2 < Ge a @2 2u < 1 ⇐⇒ Ge −u0 <e (21) Ge a <e −a 2u (22) . (1\$) or e3ui/alentl+ 'ut '0a < √ 2 GeJ'0a 2 −J 0a @2 <1 −J 0 2 (20) a @2 −Ja a *+ the definition of the first passage ti.

*iguousl+ reco/er the distri*ution function of 0 a References [1] Ste/en Shre/e.ent generating function of the first passage ti.o.e 8odels [2] Richard Eurrett.e can una.e o*tained the . Ste/en G Shre/e.ent generating function . Stochastic Calculus for :inance )): Continuous"0i. 'ro. Stochastic Calculus: 5 Aractical )ntroduction [3] )oannis 7arat6as.nian 8otion and Stochastic Calculus .o.0hus .portantL 'ecause *+ the .e 0 a 9h+ is it i.