Two Approaches to Pricing Barrier Options

Nadia Uys
9808662X
Supervisors: Theo Winter & David Tugendhaft
Contents

1 Introduction 2
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Objectives of the Research . . . . . . . . . . . . . . . . . . . . . 3
1.3 Structure of the Report . . . . . . . . . . . . . . . . . . . . . . . 3

2 Background and Related Work 4

2.1 Derivative Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.2 Complications when Pricing Barrier Options . . . . . . . . . . . . 5
2.3 Related Research . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.3.1 The Reflection Principal . . . . . . . . . . . . . . . . . . 6
2.3.2 Pricing Barrier Options . . . . . . . . . . . . . . . . . . . 6

3 Research Method 8
3.0.3 Analytic Pricing . . . . . . . . . . . . . . . . . . . . . . 8
3.0.4 Monte Carlo Estimation . . . . . . . . . . . . . . . . . . 8

4 Analytic Pricing 10
4.1 Statement of the Problem . . . . . . . . . . . . . . . . . . . . . . 10
4.2 Summary of the Method . . . . . . . . . . . . . . . . . . . . . . 11
4.3 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
4.3.1 Rainbow Up-And-Out Call . . . . . . . . . . . . . . . . . 11
4.3.2 Partial Rainbow Up-And-Out Call . . . . . . . . . . . . . 21
4.4 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

5 Monte Carlo Pricing 39

5.1 Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
5.2 Removing Bias For Continuous Monitoring . . . . . . . . . . . . 40
5.3 Variance Reduction . . . . . . . . . . . . . . . . . . . . . . . . . 42

6 Practical Example 49

7 Conclusion 51

1
Chapter 1

Introduction

1.1 Introduction
The concept of a barrier option was first introduced to the literature by Snyder in
1965 [15]. It is in recent years, however, that a vast amount of literature has been
devoted to the pricing and hedging of these options. This interest is not merely
academic, resulting from the interesting problems posed by barrier options, but an
indication of the growing popularity of barrier options in the marketplace.
A European barrier option is an option contract, similar to a standard European
option contract, which has certain aspects triggered if the underlying asset price
becomes too high or too low. There are two types of barrier options: knock-in
options and knock-out options. A knock-in option expires worthless unless the
underlying asset price crosses a predefined level before maturity. A knock-out
option pays zero if the underlying asset price does cross the barrier. The options
are said to “knock-in ” or to “knock-out” when the barrier is crossed. Barrier
options can also be described as up or down. If the barrier is above the initial
asset value, the option is an “up” option and, similarly, if the initial asset value is
above the barrier we have a “down” option. Since the payoff of a barrier option
is dependent on the level of the underlying asset along its path, barrier options
are path dependent. Although the barrier is determined in advance, it need not
be constant. An increasing barrier, for example, can be used to compensate for
expected inflation.
A constant rebate is often paid to the owner of the barrier option if it is to expire
worthless. In the case of an “in” option, it is paid at maturity if the option has failed
to knock-in. The rebate is paid at the time of knock-out in the case of an “out”
option. Carr [7] points out that since the rebate is paid out at the stochastic first
passage time in the second case and at the deterministic maturity time in the first,
the evaluation of the rebate is fundamentally different in the two cases. Rebates
will not be dealt with extensively in this report.
The popularity of barrier options can be attributed to their flexibility and to
their being much cheaper than standard options. Very specific cash flows can be

2
hedged. For example, an Up-and-In Call could be used to hedge a cash-flow that
would only take place if an asset price breached a certain level. If a speculator
had a specific view on the direction markets would take, a barrier option could be
used to pinpoint his exposure. In both cases a barrier option would cost less than
a standard option, as a result of the reduced upside potential of the barrier option.
Since the owner is not exposed to the full upside potential, he does not pay for it.

1.2 Objectives of the Research

This report deals with the pricing of barrier options, specifically non-standard bar-
rier options. By non-standard we mean barrier options that involve more than one
underlying asset or barrier options for which the barrier is not in effect for some pe-
riod or periods during the life of the option. These will be termed “rainbow barrier
options” and “partial” or “protected” barrier options respectively. In the case of a
rainbow barrier option, the barrier condition can be a function of one or more of
the underlying assets. These assets can be, but are not necessarily, the same assets
determining the payoff.
The research focuses on pricing these barrier options analytically and using
Monte Carlo simulations. In addition, an attempt is made to implement solutions
to some of the problems associated with Monte Carlo pricing of barrier options.

1.3 Structure of the Report

In the following chapter, the framework within which pricing of barrier options will
take place is presented. The chapter also deals with the specific problems one must
face when pricing barrier options and provides an overview of the background
literature that is related to the pricing of barrier options. Chapter 3 outlines the
approach used in the research.
Chapter 4 develops an analytic solution to a specific problem, highlighting the
techniques used. The Monte Carlo approach is presented in chapter 5. An ad-
justment for continuity is implemented and discussed and an importance sampling
technique is presented as a variance reduction measure.
An example of how barrier options are used in practice is discussed in chapter
6 and priced using both methods. Finally, chapter 7 concludes the report with an
overview of the research.

3
Chapter 2

Background and Related Work

2.1 Derivative Pricing

Before the pricing of barrier options can be presented, a framework in which this
can take place must be established. The approach used in this report is that pro-
posed by Merton [13] and will be referred to as the martingale pricing framework.
We assume a complete market and the absence of arbitrage opportunities. These
assumptions imply that any derivative can be replicated with a portfolio of traded
assets and that the value of this portfolio will be equal to the value of the derivative.


We also assume that the price of the asset in the replicating portfolio follows
geometric Brownian motion and has the stochastic differential  equation


       

   
!" #$ 
      (2.1)
 
# 
where the  ’s are independent Weiner processes under the real world measure
%
.
%
')(* By+-, Girsanov’s Theorem, there exists a measure & such that the processes
( . *0/1,
%  :98
54768686 are martingale under & , where  is known as the nu-
.32 
meraire '=asset.
< Then it can be shown that if the value of the replicating portfolio
. %
is ;  , (>. *0/?, 2 is martingale under & . Thus


;  EBF >
; G

@98 BADC 
@ 9H (2.2)
 GJI
We have assumed that there are no arbitrage opportunities, which implies that
the value of a derivative is equal to the value of its replicating portfolio. Hence, if
K 
 is the value of the derivative at time ,
K
K  @9H EMF G
  LA C N :98 6 (2.3)
GJI

4
 If we further assume that the risk-free rate of interest is constant and choose
the money market account as the numeraire asset, we have the martingale pricing
formula
K  EUT K
 MOQPSR G P  A C GWV 6 (2.4)
%
& is known as the “martingale probability measure”.
Furthermore, by solving the Black-Scholes formula [4], it can be shown that
%
the drift of a traded asset in the environment defined by the measure & is equal to
the risk-free rate of interest. This simplifies the analysis since this is not subjective
and the unknown drifts of the securities need not be determined. It is for this reason
that the martingale pricing framework is often called the risk-neutral environment.

2.2 Complications when Pricing Barrier Options

As mentioned, barrier options are path dependent. This makes both analytic and
numerical procedures used to price them far more complex than those used to price
standard options. When using analytic techniques, the path dependence gives rise
to conditional probabilities that are not easily solved. This is particularly evident
when pricing partial options since there is more than one dependency along the
path. Numerical techniques may be slow since the entire path must be simulated.
Analytic solutions include the implied assumption that the asset price is con-
tinuously monitored and so any crossing of the barrier will be observed and the
option knocked out. A numerical solution simulates the path at discrete points.
Thus the asset price is only observed at discrete points and the option can only be
knocked out if the barrier is observed to be crossed at one of these points. There
is, however, a chance that the stock-price rises to a level above the barrier after
being observed at point X and returns to a level below the barrier to be observed

at point X 4 . The option would have knocked out under continuous monitoring,
but remains alive under discrete monitoring. Hence, the numerical method will
be biased, overestimating the option value when monitoring is continuous since
fewer paths will be knocked out than would be knocked-out in reality, resulting in
a greater number of positive payoffs. Similarly, the price of a knock-in option will
be underestimated. This may not be a serious problem since in practice discrete
monitoring takes place.
Glasserman and Staum [8] point out that another problem associated with
Monte Carlo simulation is that since paths are knocked out, resulting in zero pay-
off, there are fewer terminal values with which to estimate the payoffs. Thus the
variance is quite large relative to the price.

5
2.3 Related Research
2.3.1 The Reflection Principal
Since barrier options are path dependent, various results pertaining to the path of a
Brownian motion can be utilised in pricing them. The most important of these is
the following result, known as the generalised reflection principal.
If Y  is a standard Brownian motion and ;  is the arithmetic Brownian motion
  
;   Y (2.5)

then, letting ZB[B\^]`_a 4cb a?dWegfD_ahYjiDe
nmo
%lk o kxy  e %lk Y}| y e~|  r
qp T ;  fDesa";GtiDYvu MOxw Z{i u (2.6)
_a1rUV r
z n
This is a generalisation of the discrete result that the probability of a reflected
random walk is equal to the probability of the original random walk (see diagram)
and is described in detail by Harrison [9].

2.3.2 Pricing Barrier Options

Analytic Pricing
The first valuation of a barrier option seems to be that of a down-and-out put in the
seminal paper by Merton [13]. The framework in which to price path dependent
options was, however, only established ten years later in 1983 by Bergman [3].
Since then the approach to pricing barrier options has been via martingale pricing
as described above. Only recently has Buchen [6] priced barrier options using the
alternative method of partial differential equations.
Rubenstein and Reiner dealt with all standard barrier options in their 1991 pa-
per [14] and Heynen and Kat analysed barrier options on two assets in 1994 [10].
Due to the established framework for pricing barrier options and the wealth of lit-
erature on the subject, as well as their popularity, many recent textbooks contain
material on pricing barrier options. Formulae exist for barrier options where the
barrier condition and the payoff condition depend on two different, correlated as-
sets. There are also closed form solutions for partial monitoring on a barrier option
dependent on one or two assets where the barrier is monitored from inception and

monitoring ceases at time  . A more complex case is when the option is protected
 
from inception to time  , monitoring begins at time  and continues to maturity.
This is more difficult to price analytically since the option can knock-out at the
point where monitoring begins if it is above the barrier level at that point, which
adds a time dimenstion to the problem. Carr [7] priced this type of barrier option
for one underlying asset.
Closed form solutions to barrier options assume continuous monitoring. This
is not what occurs in practice. To get a closed-form solution more applicable to

6
practical situations, Broadie, Glasserman and Kou [12] developed a method of
adjusting the barrier to compensate for discrete monitoring. Using this method, the
barrier option is priced using the usual formulae but with the barrier shifted away
from the underlying asset. This will give a higher price for a knock-out option,
which will be a better approximation to the price of a discretely monitored knock-
out option, and a lower price for a knock-in option. The adjustment is

Y€  Y Oc‚ ƒ „†… (2.7)
†z ‡†ˆŠ‰ ‹
if the barrier is above the underlying security, and

YŒ€  Y O P‚ ƒ „†… (2.8)
†z ‡†ˆŽ‰ ‹
if the barrier is below the underlying security.

Numerical Pricing
There has been much work on the pricing of barrier options using trinomial trees,
but this research report focuses on Monte Carlo integration as a numerical approach
to valuation. The first application of Monte Carlo pricing to financial problems
appears in the 1977 paper by Boyle [5]. The approach outlined in this paper is
applied to Monte Carlo approximation of barrier options in this report.
Beaglehole, Dybvig and Zhou [2] first applied a Brownian bridge to the Monte
Carlo estimation of path dependent options in an attempt to eliminate the bias when
estimating continuously monitored options. This work was later extended by Baldi,
Caramellino and Iovino [1].
Glasserman and Staum [8] have applied importance sampling as a variance
reduction technique in the case of “out” barrier options.

7
Chapter 3

Research Method

The problem of pricing barrier options was approached in two ways. First, the
existing techniques used to find closed form solutions for barrier options were ex-
tended to the more complex rainbow and partial barrier options. Next, Monte Carlo
integration was used to price these options, applying two different techniques to
improve the estimates.

3.0.3 Analytic Pricing

A closed form solution was derived for a specific example of a rainbow barrier
option with protection. The theory in used Carr’s paper [7] was extended to the
two asset case.
The pricing was done within the Black-Scholes framework. The stock prices
were assumed to be log normally distributed and stochastic differential equations
were used to describe their evolution under the risk neutral measure. When nec-
essary, the Radon-Nikodym derivative was applied to find a new measure under
which to work and the new Brownian motion under this measure was found using
Girsanov’s theorem. The reflection principal was used to simplify path dependent
probabilities.
Once the formula was derived, it was evaluated using an approximation to the
bivariate normal distribution which wasimplemented in MatLab and also using the
integration simplification functions in Mathematica. The input parameters used in
the valuation were those used by Carr [7]. This was done so that the results could
be compared to the results in the paper. The results were checked against prices
generated for the same input parameters using a model at JP Morgan.

3.0.4 Monte Carlo Estimation

Monte Carlo estimations were implemented using MatLab. Vectorised code was
used as often as possible to reduce running time, but this was not the emphasis of
the research.

8
 An effort was made in this part of the research to determine whether a crude
Monte Carlo estimate could be improved. A method to reduce the bias when es-
timating the price of a continuously monitored option was one method we looked
at. Another was an importance sampling technique to reduce the variance of an
estimate of the price of a knock-out option.
The approach was to price options using crude Monte Carlo estimates and to
see how well they approximated the analytic solutions. Both the continuous closed
form solution and the adjusted barrier analytic solution developed by Broadie,
Glasserman and Kou [12] were used. The proposed improvements to the estimate
were then implemented using the same input parameters and compared to the crude
estimate.
The estimates were compared for different sample sizes using the average
squared deviation over ten runs. The estimates were compared for various sam-
ple sizes as a test for improved convergence of the new methods and the average
squared deviation over ten runs was taken to reduce the possibility that an unrepre-
sentative example could affect results. The parameter values were taken from Carr
[7] and Glasserman and Staum [8].

9
Chapter 4

Analytic Pricing

It is often useful to have a closed form solution available for the price of an option
as it can give a quick and easy idea of how much the option should cost. Often
it is the starting point for a numeric solution and sometimes reveals something
pertaining to the nature of the derivative to be priced.
Usually the analytic solution can be differentiated to obtain formulae for the
greeks. In the case of barrier options, however, the derivatives can be quite un-
wieldy and so the greeks are found numerically.

4.1 Statement of the Problem

This chapter derives a closed form solution for a specific barrier option as a demon-
stration of the techniques used in pricing complex barrier options analytically. This
option can be described as a Partial Rainbow Up-and-Out Call and has the follow-

ing features:
 European style.
 Two underlying assets, Asset 1 and Asset 2.

 Protection up to time  .
  
If Asset 1 crosses the barrier between and  but is below the barrier at  ,
 ‚
 it is alive at  .

The option knocks out if Asset 1 is above the barrier at  or if the barrier is

 crossed between  and maturity.
The payoff condition depends on Asset 2. If the option is still alive at ma-


turity then the payoff is ’‘ w ] G |”“•ah_ b where “ is the strike price and

 z
G is the value of Asset 2 at maturity.
z  
The case of an option that has a barrier in effect from to  and not afterward
 ‚
(in other words, the option is protected from  to maturity) has been studied. The
case presented here is more difficult to price and has not been extensively analysed.

10
4.2 Summary of the Method
The solution presented in this chapter is an extension of the theory in Carr [7]. The
pricing takes place within the martingale pricing framework described previously.
The stochastic differential equations used to describe the asset prices are geometric
Brownian motions with respect to the risk neutral measure.
A formula for a rainbow up and out call with no protection will first be de-
rived. This formula was first derived by Heynan and Kat [10] but it is useful to
present the derivation using the methods that will be applied when extending the
formula to partial barrier options. The reason for this is that the derivation includes
intermediate results that are used in the extension.

4.3 Valuation
4.3.1 Rainbow Up-And-Out Call
 
The option is knocked out if  rises above Y—–  before the option expires at
‚ 
r . If the barrier is not hit prior to r , then the payoff at r is max ˜q_ , G |™“›š .
z
Risk Neutralized Processes:

œ ( (ž  . ž #

(œ Ž¢ .  ] Ÿ|¡Ÿ  b  ‚  
. 
 
  
 #  ¢ ¤#
(Š¢ 
. œ ž (  (Ž¢ = ] Ÿ|¡Ÿ b ] £ ‚  ] 4 |¡£ b ‚ b
(  . œ( ¢ . 
ž Np  T z
cov ] . a . b  za _z a1rUV z
T  z T
# •p # •p
where ‚  , _a1rUV and ‚  , _a1r¥V are independent standard Brownian
%
motions defined on a probabilityz space ( ¦ , § , ‚ ). These SDE’s have the solution:

    #
   Ÿ|¡Ÿ  | z
 y®  ‚ 
‚W¨H©¤ª•«¬« ­  ­ 
¢
   #  k # Np T
  Ÿ|¡Ÿ | yz ­ £ ‚  4 |¡£ u ‚ ±° a _a1rUV
‚ ¨H©¤ª•«¬« z  z¬¯ z ­
z z z z (4.1)

Using risk neutral valuation, the value of a European Up and Out call option is:

11
²³1´  ¸º¹ 
 ]?|UŸŽr b?Aµ‚·¶`¸º¹ ˜c_a Gl|™“tš 4  ©  ½¼ Y
‚ ¨H©¤ª © « _)i i»r ­q¾
z
   max 
 ]?|UŸŽr b?Aµ‚ ¶ ] 4 ] Gt–D“ b G’| 4 ] G™–D“ b “ b 4   ½¼ Y
¨H©¤ª « _ºi i¿r ­À¾
z z z
 max  
 exp ]?|UŸŽr b?A ‚·¶ 4 G¡–D“la  G ¼ Y ] G’|™“ b
« _vi i”r ­ ¾
z z
T  ¸º¹ 
 exp ]?|UŸŽr b?A ‚ 4 G¡–D“•a  © G ¼ Y
« _vi i”r ­DÁ 
z ¢ #
  # 
Ÿ|¡Ÿ |  z r £ ‚ G ] 4 |¡£ b ‚G ° V
‚ ¨H©¤ªÂ«¥« yz ­  z ¯ z ­
z z z
 max 
| exp ]?|UŸŽr b “ Aµ‚ ¶ 4 Gt–D“la  G ¼ Y
« _vi i”r ­q¾
z
 max  
 exp ]?|UŸ r b?As‚)¶ÄÃ>4 G –D“•a  G ¼ Y
« _vi i”r ­À¾ ‚
z z z
 max 
| exp ]?|UŸŽr b “ A ‚·¶ 4 Gt–D“la  G ¼ Y
« _vi i”r ­q¾
z
where


 #  ¢ #
õ |  z r ] £ ‚ G ] 4 |™£ b ‚G b
¨H©ª « yz  z z ­
z 
£ r  # ] 4 |Å£ b r  ¢ #
 | z y z £ ‚ G | z z ] 4 |¡£ b ‚G
¨H©ª•« z  z y  z  z z ­
z

%  œ EWÆ
Define an equivalent probability measure by œ E Ç Èà . Then bu Gisanov’s
Theorem,

#É # 
  ‚  |¡£ 
#É #  z ¢ 
  ‚  |~] 4 ¡ | £ b
z 
z z z
% 
are standard BM’s on the probability space ]ʦah§Àa b.
% 
Now under the measure :

12
 
 Ë  #   
  ] ŸŒ|ş  b  ]  £ b
  
 žË #É z 
 ] ŸŒ|ş   £ b  
   z ž ¤ #$
 ] ŸŒ|ş   b    
   ¢  $ ¢
 Ë z T  #$    #   
 
] ŸŒ|ş b £ ]  £ b ] 4 |¡£ b ]  ] 4 |¡£ b bV
z  z  z z 
¢  z  z
z z
z  ] ŸŒ|ş  £ 
] 4 |¡£ b b
ž
] £ 
¤#$ 
  ]4 ¡ | £ b
 #É
 b
 z  žz  z¤#$  z   z ¢ #É z
 ] ŸŒ|ş z b z ] £  z ] 4 |¡£ b b z
z  z  z
or equivalently z z

     # 
   ŸÌ|¡Ÿ   | yz ­  
‚ ¨H©ª «¬«  z  ­ 
   Ë #   ¢ # 
  yz b ŸÌ|¡Ÿ ] £  ] 4 |¡£ b 
‚W¨H©ª•«¬« ­¥­
z z z
z  z z z
# #    # #   ¢ 
by substituting ‚  =   £ and ‚ =  ] 4 |¡£ b into (4.1).
 z z  z
z z
Thus

²³?´    max 
 ]?|UŸ r ?b A ?¶ 4 G¡–D“•a   ½¼ Y
‚ ‚ ¨H©¤ª « _vi i”r ­À¾
z z z
 max 
|™“ ]?|¥ŸŠr b?µ A ‚ ¶4 G –~“la
™   ½¼ Y
¨H©¤ª « _)i i”r ­q¾
z
 %)  max 
 ]?|UŸ r b ¶ G™–¿“•a   ½¼ Y
‚ ¨H©¤ª _)i i”r ¾
z z z
%  max 
|™“ ]?|¥ŸŠr b ‚·¶ G –D“la    ¼ Y
¨H©¤ª _)i i¿r ¾
z
Consider the change of variable Í

Í  qp T
  BÎÐÏ ]  b a _a1rUV 6

‚
Note that   _ and that from Ito’s Lemma
‚ Í

 4    4 4 
    |  ] b
 y  z
z
 žË ¤#
 Ÿ|¡Ÿ  | yz ­  ‚ 
« 
ž #
 ‚   ‚ 

13
 ¢
where  ‚   Ÿ|¡Ÿ  | .
ˆ
Also z
Í

   ž ¤# 
] Ÿ|¡Ÿ  |  z    b  
y
 ž  #   z
¤ 
   
¢ 
 
where    Ÿ|¡Ÿ  |  .
ˆ 
Also, consider the change z Í of variable z

Í  Np T
 MÎÏ  a _a1rUV
« z ­
z ‚
Note that  _ and that from Ito’s Lemma z
Íz ‚

 4 ¤   4 4 ¤
    |  ] b
 y  z
z z z z 
z z ž #  ¢ ¤ #
 Ÿ|ş |  z ] £ ‚  ] 4 |¡£ b ‚ b
« yz ­
®  z  z
 z  #
  ¢ ¤# z
B ‚ ] £ ‚  ] 4 |™£ b ‚ b
¢  z
z ¢ z z
where  ‚  Ÿ|¡Ÿ | .
ˆ
Also, z z z
Í

  ž #   ¢ ¤ # 
  Ÿ|ş  y®z ] £  ] 4 |¡£ b b
« z ­  z z
z ¢ z z
 
where   Ÿ|¡Ÿ .
ˆ % %
z measure
Define az probability z Ñ ‚ , equivalent to ‚ , by
 %
Ñ ‚  ‚ # 4  ‚
 %  exp ˜ž| ‚ G | ] b rҚ 6
‚  y  z
 
Then, from Gisanov’s Theorem,Ó

Ó
# #   ‚ 
‚   ‚ 

# # 
‚  ‚
z z %
are standard BM’s on the probability space ]ʦah§ÀaÔÑ ‚ b .
%
Note that under the measure Ñ ‚

14
 Ó
Í
Ó Ó
 Í  #
   ‚ 
 Ó Ó 
  
ž  #  ‚   ¢ #
 ‚ ¶£ ‚  | ] 4 |™£ b ‚
 «  ­  z ¾
z z ž  T #   ¢ # z
  Ñ ‚ £ ‚  ] 4 |¡£ b ‚ V
 z z
z z
where

 ‚
Ñ ‚  ‚ | £
 
z z  z
 ‚ |  ‚  £ 
z
z  
 Ÿ|¡Ÿ |  z | ŸÌ|ş  |  y® z £ 
yz « ­ z
z  z

 Ÿ  |¡Ÿ |  z y 
yz  z
z
Note that

 %
 ‚ Ó #
‚  4  ‚
 % 
‚ G z rØ×
Ñ ‚ ¨H©ªÖÕ  y «  ­
 
 ‚ Ó #  ‚  4  ‚ (4.2)
 exp ˜ ] ‚ G | r b ] b rҚ
  y  z
 ‚  # 4   ‚ 
 exp ˜ ‚ G | ] b rҚ
 y  z
 
%  % 
Similarly, define a probability measure Ñ equivalent to by
 %
 
  #  Ñ  4  
 %  | G | z rØ×
 ¨H©¤ªØÕ  y «  ­
 
Then from Gisanov’s Theorem Ó

Ó 
#$ #É    
  

#$ #É 
  
z z % 
are standard BM’s on the probability space ]ʦah§ÀaÔÑ b .
% 
Note that under the measure Ñ

15
 Ó
Í
Ó Ó
 Í  # 
   
 Ó  Ó 
  ž  #$     ¢ $# 
  ¶£  | ] 4 |¡£ b 
 z «  ­  z ¾
z z ž  #$   ¢  #$ z
 Ñ  ] £  ]4 ¡
| £ b b
¢ z  z z
    z
where Ñ    | £  .
ˆÙ
Let z z ˆ

'
max  
%
 ‚U Í  ½¼ YÚa Í t ‚ G –D“ 2
_vi i”r
' z
% max
 ‚   Û¼~Ü a G –~“ 2
™
_vi i”r
z
Í
( ž  Ž
( ¢
where Ü BÎÐÏ Ç ° and “ BÎÏ Ç ° .
Let ß}G à  ¯ØGÝ
max  ¯)Þ
Ù ‚ á á
Then
Í

% Í
‚¥ ‚ ˜  –âãahß G à  ¼ Ü š
BAs‚ ˜ 4 ] z Gt͖~âãahß G à ¼~Ü b š
 % Ó
‚z
 As Ñ ‚)¶  % 4 ] G –~âãahß G à ¼~Ü b Í
Ñ ‚ ¾
' z
 ‚ # 4  ‚ Ó
 ÑA ‚ ¶ b r 4 ] ¼~Ü b
¨H©ª 
‚ G |
y
]
 z 2 Í ahß G à
Gt–~âã
¾
  z
4  ‚  ‚ #
 | z r¬å=ÑA ‚ ¶ ˜ ‚ š 4 ] Gt–D“•ahß G à ~ ¼ Ü b
¨H©ªÅä y «  ­ ¨H©¤ª Í G Í ¾
 z
'
4  ‚  ‚
 | z r¬å=ÑA ‚ ¶ ‚ G
2 ]
4 Gt–~âãahß G à ~¼ Ü b
¨H©ªÅä y «  ­ ¨H©¤ª  ¾
  z z
Ó
since
Í
Ó
 Í  #
Ó    ‚ 
æ Í #
   ‚ 
 
æ # ‚  



16
Ù Ó
Í
Ç¢ 
4  ‚  % # plÓ
ë
‚¥ | z r ×èç”é S O ê à Ñ ‚ ˜ Gt–~âãahß Ó G à ¼~Ü a  ‚ G w  š Ó
¨H©ª Õ y «  ­ 
 P Ç¢  z 
é  % ¢ #
4  ‚ ë  #  # pl
 | z r × ç é O ê à Ñ ‚ ˜ Ñ ‚ r Ó ] £ ‚ G ] 4 |™£ b ‚ G –~âãahÓ ß G à ¼~Ü a  ‚ G w  b š
¨H©ª Õ y «  ­
 P Ç¢  z
 z ¢ z z

Ó Ó é  
4  ‚ ë à % # â)| Ñ ‚ rD| £ w  % # pl
 | z rØ× ç”é O ê Ñ ‚ ‚G – ì ˆ × Ñ ‚ ˜  ‚ G w  ahß G à ¼Ü š
¨H©ªÖÕ y «  ­ Õ  z 4 |¡£ ˆ
P Óz z Ó
# #  é z
since ‚  and ‚  are independent BM’s. ¢
Ç¢  
z 4  ‚  % # â·|  Ñ ‚ rD| £ w  % # pl
ë
 | z r × ç í é O ê à Ñ ‚ ˜ ‚G Ó – ì ˆ š Ñ ‚ ˜  ‚ G Ó w  ahß G à ¼~Ü š
¨H©ª Õ y «  ­  z z 4 |¡£ ˆ 
 Ç   z ¢
Ù Ù í ¢ z 
 î
t 4  ‚  # â·|  Ñ ‚ r¿| £ w  # pl
ë à % %
| z rØ× ç O ê Ñ ‚ ˜ ‚G – ì ˆ š Ñ ‚ ˜  ‚ G w  ahß G à ¼~Ü š
¨H©¤ªÖÕ y «  ­  z z 4 |¡£ ˆ 
Ó  P z
 é z
 Ù 
% z#
Now Ñ ‚ ˜  ‚ G – Ü ahßïG à ¼Ü š  _
Thus    _
Thus
Ù Ó Ó

Ç¢  ¢
í  % 
4  ‚ ë # ·
â |  Ñ ‚ r D | £ w Ó % # p•
‚  | z r ×èç O ê à Ñ ‚ ˜ ‚G – ì ˆ š Ñ ‚ ˜  ‚ G w  ahß G à ¼~Ü š
¨H©ª Õ y «  ­  z z 4 |¡£ ˆ 
 P Ç¢  z
íé z
4  ‚  4 w  % # p•
ë
 | z Ø r × ç O ê à ç é ] b w Ñ ‚ ˜  ‚ G w  ahß G à ¼~Ü š
¨H©ªÖÕ y «  ­ ð rÚñ z r 
 P Ç¢   z   z  z
8Ù ò ÙHó íé 
4  ‚ ë 4 w  4 w  w  | y Ü 
 | z r × ç O ê à ç é ] b w ] ] b | ] b†b w 
H¨ ©ª Õ y «  ­ ð r ñ z r  r ñ  r ñ  r
 P  z   z  z      
 é
|

by the reflection principle, where

¢

â·| Ñ ‚ D r | £ w 
‘  ì ˆ
z 4 ¢|™£ ˆ
4 ¢ z
]`ô b
 O P÷ö
ñ yQõ

Now

17
 ' Ç  
4
 ‚ w  4 4  ‚   ‚ 4 w 
| ] b r O ëê à  | z r w  | z ×
¨H©ª y  z 2 ñ «  r ­ yQõ ¨H©ªÖÕ y «  ­  y  r
    '   z  z
4 4 
 | w
]  | y r ‚ w   ‚ r b
yQõ H¨ ©ª y  r z z z 2
  z
w  |  ‚ r

ñ «  r ­
 
Thus Ù8ò

í
w  |  ‚ r
4 4 w  
 ç ç é w w 
ð  rÚñ «  r ­ r ñ «
Ú z r ­
P      z   z  z
é
Let ø

ø w  |  ‚ r
 
 r
 
 w 
 
 r
 Ü |   ‚ r
ÜUù
 r
|Ìú ù |ú 

Let ø

' 
ø 4 ¢ 
 |

] 4 |Å£ b w  z  £ã] w  |  ‚  r b 2
r ¢ z
z  z  ø z ø 
 ] 4 |™£ b 
 | z w
r
z ø  ø  z¢ 
| z r £ã]  r  b
w   z  ì ˆ  
z 4 |¡ ˆ £
z  z
æ w |s] £  b
 ì
z r z 4 |¡£
 z  z
¢ ú ù |Ìú ¢
   
â·|  Ñ ‚ rD| £ w  |¬â Ñ ‚ r  ‚ r
‘  ì ˆ ù ˆ £
z 4 |¡£ ˆ z r ˆ
z  z 
Thus

18
 ø ø
Ù8ò ø ø ø
¢
Ç þý
/  Ç¢ ý ë  ǝ ý
-ÿ ý ¢†ÿ ý ë  
ë ê ë ê 4 |s] £  b  
 çgûÊü ê ç ü ]  b ì 
P P ñ 4 |Å£ ñ « 4 z |¡£ ­
z z z
é éø ø
ø
Now ø ø ø ø ø

 ø ø ø  ø 
4 |s] £  b 4 | 4 
]  b ì ] b½ ì ] ˜  ] 4 |¡£ b y £  £  b š
ñ 4 |™£ ñ 4 z |™£ yQõ ø 4 |¡£ H
¨ ¤
© ª y ] 4 |¡£ b z z z z z
z z ø z z z z
4 | 4  
 ì ˜ ]  y £  b š
yQõ 4 |¡£ ¨H©¤ª y ] 4 |¡£ b z
z z z z

 ]  a |U£ b
ñ
z
Thus
Ù ò ø ø ø ø
¢
Ç -ý /
 Ç¢1ý ë  Ç þ ý
ÿ ý ¢ ÿ ýë 
ë ê ë ê  
 çgû±ü ê ç ü ]  a 
|U£ b 
P P ñ ¢
   z z
é Ü |  ‚  r é |¬â Ñ ‚ r  ‚ r 
 \ ] a ˆ |¥£ b
 r z r ˆ
z    z 
Now

Ç¢  '
 ‚ 4  w  | y Ü 4 4  ‚   ‚ 4 
ë
| O ê à
z r ×   | ] b r w  | ] w  | Ü w   Ü b
¨H©ª Õ y «  ­ ñ «  r ­ Qy õ ¨H©¤ª y  z  y  r z z 2
    '   z  z
4 4  
 | ]  ‚ r | y  ‚ r w  w  | Ü w   Ü b
Qy õ ¨H©¤ª y  r z z z z 2
 4 '  z
4   
 | ] w  | y w  ] ‚  r¿| y Ü b ] ‚  r y Ü b  ‚  r Ü
yQõ ¨H©¤ª y  r z z
 4 '  z '
4  y  ‚ Ü
 | ] w  |~]  ‚  r y Ü b†b 2 2
yQõ H¨ ©¤ª y "r z ¨H©¤ª 
 '  z    z
y  ‚ Ü w |~]  ‚  r y Ü b

¨H©ª  2 ñ «  r ­
 z  
ÙHó
Thus

í '
y  ‚ Ü w  D
| ] r | y Ü b
 ‚ D w 4 4  
 ç ç é H¨ ©¤ª w w 
ð  2 ñ «  r ­ ñ « z r ­  r r
P  z    z     z  z
é
Let

19
 
w  |~]  ‚  r y Ü b
Z  
 r
  
 w 
Z  
 r
 | Ü |  ‚  r
Üqù
 r
|Ìú ù |Ìú 


Let

' ì
4  
Z  | 4 |¡£ w  z  £ã] w  |~]  ‚  r y Ü †b b 2
r z z
z ì z  
 4 |¡£ 
Z  | z w
r
z z
ú ù |Ìú  z  ¢

â)|  Ñ ‚ rD| £ w 
‘  ì ˆ
z 4 |Å£ ˆ ¢
 z  
|¬â Ñ ‚ r £W]  ‚  r y Ü b
ù ˆ
z ˆ r
 z 
Thus
ÙHó
¢ ¢ ,
ǝ ý /
 Ç1¢ ý ë
 * Ç þ ý
ÿ ý ¢ë ÿ ý ' 
ë ê ë ê y  ‚ Ü 4 | ]±Z
s £Z  b  
 ç Qü û±ü ê ç ü û ] ± Z  b ì ì å Z Z 
¨H©ª ¢  ¢2 ñ 4 |™£ ñ ä z4 ¡ | £
P P /
 Ç¢1ý ë 
* Ç þ ý z , z
é ' Ç þý é z z
ÿ ý ¢ë ÿ ý
y  ‚ Ü ë ê ë ê  
 çLüQû±ü ê ç ü û ±] Z  a"Z  ¥ | £ b Z Z 
¨H©¤ª  2 ñ¢
'  z P P    z  z
y ‚  Ü é | Ü |  é ‚ r |Ìâ Ñ ‚ r £ã]  ‚  r y Ü b 
 \ a ˆ |U£ å
¨H©¤ª  2 ä  r z ˆ r
 z z    z 
% 
Similarly for .
Thus the price is:

20
 ¢
¢      
   G T Ü |  r |¬â Ñ r  r 
 ‚  O PSR \ a ˆ £ |U£ å
‚ ä  r z r ˆ
z z ¢
'  Ü     z      
y   Ü |  r |¬â Ñ r £W]  Dr | y Ü b 
| \ | a ˆ |U£ å V
¨H©ª  2 ä  r
¢
z ˆ r
 z z      

G T Ü |  ‚ r |¬â Ñ ‚ r  ‚ r z 
|™“ O PSR \ a ˆ £ |U£ å
ä  r z r ˆ
z ¢
'    z     
y  ‚ Ü | Ü |  ‚ r ¬
| â  Ñ ‚ r £ ]
W  ‚ r y Ü b 
| \ a ˆ |U£ å V
¨H©ª  2 ä  r z ˆ r
 z z    z 
where

Y
Ü MÎÏ 
« ­
‚
“
â MÎÏ 
« ­
‚
z 
 ‚  ŸÌ|™Ÿ  | yz

 ‚  ŸÌ|™Ÿ | yz
z
z z
Ñ ‚ B ‚ |  £  ‚
z
z z 
  
   ŸÌ|™Ÿ  |  z £ 
y  z 
 
  ŸÌ|™Ÿ yz
z
z  z 
Ñ B |  £  
z
z z 
4.3.2 Partial Rainbow Up-And-Out Call
The SDE’s are as before, and the Martingale pricing formula for the option is

² G T   
{OQPSR µ A ‚ º ¸ ¹ c˜ _a GÂ|™“tš 4 ]èf”r¥a   ¼ Y b V
‚ Ù ©
G z ¸º¹   
{OQPSR Aµ‚ ¶ ¸º¹ c˜ _a G•|™“tš 4   ©  ½¼ ØY a  ¼ Y
© «  i i”r ­q¾
G z
{OQPSR
Í Í
   
Where  is the first time after that   Y , conditional on   ¼ Y .
Let   ,  , â , Ü , be as before.
z
21
Ù

T   
BA ‚ Ö ¸ ¹ ˜c_a G |™“tš 4 ]èf”r¥a   ¼ Y b V
T  ©    
BA ‚ ˜ G 4 ] z G™–D“ b |™“ 4 ] Gt–D“ b š 4 ]èf”r¥a   ¼ Y b V

z z   z   #  ¢ #
BA ¶14 G™–~“laèf¿r¥a   ¼ Y b ŸÌ|™Ÿ |  z b r ] £ ‚ G ]4 ¡
| £ b ‚G
‚ ‚ ¨H©ª•«¥« yz  z ­¬­À¾
zT    z z z z
|™“ A ‚ 4 ¢ ] G™–D“•aèf”r¥a   ¼ Y b V
 G z T    T   
 O R PSR Aµ‚ Ã>4 ] G™–D“•aèf”r¬a   ¼ Y b VS|™“ Aµ‚ 4 ] Gt–D“la’f”r¥a   ¼ Y bV
‚
z ¢¢ z 
¢ # z
 # 
where õ ]?| r ] £ ‚ G ] 4 |¡£ b ‚  G b†b
¨H©ª ˆ  z %  z œ E
Define an equivalent z probability measure by œ E z Ç Bà .
Ù % 
The results in the previous derivation that are related to still hold.
¢
   TÍ  Í   Í T  Í  
 O R PSR ¢ A 4 ] G™–D“•a’f¿r¥a   ¼ Y b V|¡“ Aµ‚ 4 ] Gt–D“lalf”r¥a   ¼ Y bV
 z‚ %  T
v z –~âãaèf”r¬a    ¼~Ü VS|™“ % ‚
T 
 O R PSR G™ G™–~z âãaèf”r¬a   ¼~Ü V
‚
z z z
The asset value and Í strike are each multiplied by the probability that the up and out
option  ¢ finishes in the money (under different measures). This probability is (letting
   ¢ 
ß      )
Í á á Í Í Í

% T  % T Í   Í
‚ Gt–~âãa èf”r¥a   ¼Ü V  ‚ G™–~âãahß  G ¼~Ü a   ¼~Ü V
% T z  Í  Í 
z  ‚ ß  ¼DÜ a G^–~âãahß  G ¼~Ü a   ¼~Ü V
 % T‚  Í  
‚ ß  – Ü a z Gt–~âãahß  G ¼~Ü a   ¼~Ü V
% T ‚ Í Í
 ‚ ß G ¼~Ü a Gtz –~â V
 % T‚   
‚ ß  ¼~Ü a z Gt–~âãahß  G ¼~Ü a   ¼~Ü V
‚
z
This is the probability that an up and out Rainbow barrier option with no protection
finishes in the money, added to the probability that the barrier is breached within
the initial protection period and the option finishes in the money. We know the
value of the first term from before. Let

22
Ù
Í Í

% T  Í  Í 
‚  ß  – Ü a G –âãahß  G ¼Ü a   ¼Ü V
‚ T ‚ 
BA ‚ 4 ]`ß  – Ü a z Gt– Í âãahß   G ¼Ü a    ¼ Í Ü bV
 % ‚
‚ Ó  z  
 ÑA ‚ ¶  % 4 ]`ß  – Ü a G™–âãahß  G ¼Ü a   ¼~ Í b¾
Ü
Í
Ñ ‚ ‚
z
F  ‚ # 4  ‚   
 µ ÑA ‚ ‚ G | z r × 4 ]`ß  – Ü a G –~âãahß  G ¼~Ü a   ¼~Ü b
¨H©ª Õ  y «  ­ Í ‚ Í Í I
  z
'
4  ‚  ‚   
 | z r × µ ÑA ‚)¶ G 4 ]`ß  – Ü a Gt–~âãahß  G ¼~Ü a   ~ ¼ Ü b
¨H©ª Õ y «  ­ H
¨ 
© ª  2 ‚ Í Í Í ¾
 Ç¢   z z
4  ‚  %    p 
l
ë
 | z r × ç é O ê à Ñ ‚ ]`ß  – Ü a G –~âãahß  G ¼~Ü a   ¼~Ü Ó a  G w  b
¨H©ª Õ y «  ­ ‚
 P Ç¢  z 
é  ¢ #
4  ‚ ë %   
 | Í z r Í ×èç é O ê à Ñ ‚ ]`ß  – Ü a  Ñ ‚ r  z £ w  ] 4 |¡£ b ‚ G –~ã â a
¨H©ª Õ y «  ­ ‚  z z
   P z Ó  z
é p’ w  b
ß  G ¼~Ü a   ¼~Ü a  G ¢
Ç¢  
4  ‚   # ·
â |  ‚ D
r | £ w 
Í Í ë à %  Ü Ñ
 | z rØ× ç”é O ê Ñ ]`ß ‚ – a ‚ G – ì ˆ a
¨H©ªÖÕ y «  ­ ‚  z z 4 |¡£ ˆ
  P z Ó
 p’ z
ß  G ¼~Ü a   ¼~Ü a  G é w  b ¢
Ç¢  
4  ‚  % â)| Ñ ‚ rD| £ w  #
ë à ¼
 | z r ×èç Í é O ê ÑÍ ‚ ì ˆ ‚G å
¨H©ª Õ y «  ­ ä z 4 |¡£ ˆ 
 P z z
%   é  pl z
Ñ ‚ ]`ß  – Ü ahß  G ¼Ü a   ¼Ü a  G w  b
‚ Ç¢ 
4  ‚  4 w 
ë
 | z r ×èç”Í é OSê à ç” Í é w
¨H©ª Õ y «  ­ ð Ú
r ñ « z r ­
 P  pl   z  z
%   é 
Ñ ‚ ]`ß  – Ü ahß  G ¼Ü a   ¼Ü a  G z w  b
‚ Ç¢ 
4  ‚  4 w 
ë
 | z r ×èç”í Í é Oê à ç» Í é w
¨H©ª Õ y «  ­ ð r ñ « z r ­
     pl   z  z
% z
Ñ ]`ß ‚  – ahß Ü  G 
¼ Ü a   
¼ Ü a  G w  b
‚ í Ç¢ 
 4  ‚  4 w 
ë
| z r × Íç O ê à Í ç”é w
¨H©ª Õ y «  ­ ð Ø
r ñ « z r ­
  P z
%  é  ¼Ü pl  z   z 
Ñ ]`ß ‚  – Ü ahß  G 
¼ Ü a   a  G w b 
‚
Where
¢

â)|  Ñ ‚ Dr | £ w 
‘  ì ˆ
z 4 |Å£ ˆ
z
23
 Ù Ù Ù
So

4  ‚ 
 ˜ž| ] b rҚ ]  b
‚ ¨H©¤ª y  z
 z
Now
Í Í
Ù
Ù %   
Ñ ‚ ]`ß  – Ü a  ¼~Ü ahß  G ¼~Ü a G – Ü bÛ _
‚
Thus   _ .
To find , consider Í Í Í Í
z
%    %  Í  Í
Ñ ‚ ]`ß  – Ü a  ¼ â  ahß  G ¼~Ü a G ¼ â ½ b  Ñ ‚ ]`ß  – Ü a   ¼ â  a  G ¼ â b
‚ Í ‚   
z %
| Ñ ‚ ]`ß  – Ü a   ¼ â  ahß  G – z Ü a  G ¼ â b
‚
 hits Ü  , the first z
Í path the first
By reflecting the Í time that Í probability isÍ

%   % Í   Í
Ñ ‚ ]`ß  – Ü a  ¼ â  a G ¼ â ½b  Ñ ‚ ]`ß  – Ü a  – y Ü t | â  a  Gt– y Ü |tâ b
‚ ͂  Í
z  % z
Ñ ‚ ]  – y Ü |tâ  a  G™– y Ü |tâ b
% 
 Ñ ‚ ]?|  i~â  | y Ü a8|  G™i~â z | y Ü b
 
â  | y Ü â | y Ü   z
 a Í  \ å
  z r ä r
z     
By reflecting this reflected path the first time after  that  hits Ü  the second
probability is Í Í Í Í

%    %  ÍÜ  
Ñ ‚ ]`ß  – Ü a  ¼ â  ahß  tG – Ü a â ½ b  G ¼ Ñ ‚ ]`ß  – a  – y Ü |tâ  a†  G ¼~Ü a  G^– y Ü |tâ b
‚ ‚
z èX z
where   G     Í Í
 ¼ ¼ r
% Í   Í 
 Ñ ‚ ]`ß  – Ü a  – y Ü t | â  †a   G ¼~Ü a G ¼ â b
‚Í  Í
% z
 Ñ ‚ ]  – y Ü |tâ  a G ¼ â b
% 
 Ñ ‚ ]?|  ¼ â  | y Ü a G ¼ zâ b
 
â  | y Ü â 
 z
 \  a | å
ä   z r r
z    
Thus
Í Í
 
%    | Ü | Ü 

Ñ ‚ ]`ß  – Ü a  ¼~Ü ahß  G ¼~Ü a  G ¼~Ü bÛ \  a å
‚ ä    r r
z      
| Ü Ü  
|™\  a | å
ä    r r
z    
24
 Ù

í Ç¢ 
4  ‚  4 w 
ëò
 | z r ×®ç Oê à ç”é w
‚ ¨H©ª Õ y «  ­ Í ð Í r®ñ « z r ­
í  P  z    z
é
%   pl   pl z
ç Ñ ‚ ]`ß  – Ü a   w ahß  G ¼DÜ a G w  b
‚
P í Ç¢ 
é 4  ‚ ò  4 w
ë 
 | z rÚ× ç O ê à ç é w
¨H©ªÖÕ y «  ­ ð r ñ «
® z r ­
 P  z   z  z
í ò é 
4 w | y Ü w  | y Ü 
 ò
ç   a å
 r  ñ ä    r r
P  z  z    
Ù8ò é ÙHó  
4 w | y Ü w     
|   a | å w w 
 r  ñ ä    r r
 z  z    
 |

Let ø

ø
w  | y Ü
 
ø  r
  
w   r  y Ü
   w 
 
ò r
ø ò  | Ü
Üqù
 ò r
ø ò w | y Ü
and let  
 
 
 w
 
 
 | Ü
Üqù 
 
 
Then Ù8ò

þÿ ý Ç ¢   í

 ‚ 4 ë ë G ø  ø ò ø ò ø
 | z rØ× ç û O ê ˆ ‰ z
¨H©ªÖÕ y «  ­
 P
é    
4 w  P ë . 
  
ç é w ç û  a å 
ð rÚñ « z r ­ ‰ ñ ä r
 z   z  z P z
é
Now

25
 ø ø

   |¡£ w ø ø 
ç ç ]w a £ b wl ç ] wb \ ì å w
ñ ñ ä  4 |¡£
P P z P
é é é   " ¢ z
 
 ç ] wb ç ! ü ] b w
ñ ‰ ü ñ
P P
é é
Thus Ù8ò

ÿ ý Ç¢   
í
4  ‚ ë ø ë  ø G
ò  ø ò  ø
 | z Ør × ç û O ê ˆ ‰ z
¨H©ªÖÕ y «  ­
 P ´
4 w é   
ç é ç ]  b ] b w 
ð r®ñ « z r ­
P ñ ñ
   z  z
.ý z  é
 
P ë . % P $


where # û
‰$  .ý
P
Now ø ø ø

Ç¢  ' 
í '

 ‚ 4 ë G& 4 4  ‚   ‚  ø  ‚ 4 ø
| z r × O ê ˆ ‰ 
z ñ ] bÛ | ] b r r   y Ü | 
¨H©ª Õ y «  ­ yQõ ¨H©ª y  z     y z 2
  '  ø  z  z
4 4 
 | ]  ‚ r | y  ‚ U r r   |  ‚  r Ü   r b
Qy õ ¨H©ª y "r z z   z  z
 4 '  4z ø 
 | ]†]   r b | y   r r  ‚  ‚  r | 
yQõ H¨ ©ª y  "r  z   z z
 4 ø '  z '
| 4 y  ‚ Ü
 rD| ]   ‚  r b
yQõ ¨H©ª y  r   z 2 ¨H©ª  2
  z '  z
  r~|  ‚ ø r y  ‚ Ü
    å
ñ ä H¨ ©ª  2
'  z  z
y  ‚ Ü  ‚ r
  |
¨H©ª  2 ñ «  r ­
 z  
Thus
Ù8ò ø ø ò ø ò ø

' -ÿ ý ´
y  ‚ Ü P ë  ‚ r 4 w   
 ç û ç ð é ç  a8| ] b w 
¨H©¤ª  2 ñ «  r ­ r ñ « z r ­ ñ
 z P P    z   z  z
é é
Let

26
 ø

ø ø
m  ‚ r
  |
 r
   
 
Ü | Ü | Ü  ‚ r
| ù
 r  r
 Ì| ú ù |Ìú 


Let ø

' ì
4 
 | 4 |¡£ w  z  £W]  r  | ‚  r b
r z z   2

  z 4 ì 
 | 4 |¡£
 r z
ú ù | ú z  ¢
 ø
â)| Ñ ‚ r~| £ w 
‘  ì ˆ
z 4 |¡£ ˆ ¢
z  ø ø
â)| Ñ ‚ r~| £ã]  r  y Ü b
 ìˆ  
z ˆ 4 |¡£
| 4 z  
ù ]Êâ)|  Ñ ‚ rD|  £ã]  r  y Ü b†b £ ]  r
 z W  |  ‚ r b
r z    
 |z  4 z   
 ]Êâ)|  Ñ ‚ rD|  z  £ã] ‚  r y Ü b†b
r ¢
 |¬z â    ‚ r  z  £ã]   ‚  r  y Ü b
Ñ
 ˆ
z ˆ r
 z 
Let

27
 ø ò ø

   
î  ø ò   ‚ r
 4 |  |
r r «  r ­
   
žî  
 4 | ø
r
|Ìú ù |Ìú

P í  

 |)( G
#   ø ø
ˆ ‰ 
( 4 | G
     
| Ü      ‚ r
ù  |   |
  r r r  r
 
| Ü   ‚  
  | 
  
 Ü     
| | ‚
 
 
 
Thus
Ù8ò
¢ , ¢
Ç þý /
 Ç-¢ ý ë 
* Ç þ ý
-ÿ ý ¢1ë ÿ ý
y  ‚ Ü ë ê ë ê
 ˜ š çLüûÊü ê ç ü û
¨H©¤ª 
  ǝ  . z P
é
P
é î  m
 -.
ë . m |)(
m 4 ] |]?|U£ b b 4 G žî¬ m
ç üQû±ü ê ] b ì | ì å  +



P
‰ ñ 4 |¡£ ñ ä  4 |¡£ 4 | ñ *, 4 | G
z z
( G ( 
é ¢
ì  m
since  ¢P  ˜ 4 |¡£ w

£W]  r b š
ì G ˆm
æ |   z z  
r   ˆ ‰ 4 |¡£ w £ r ˆ

æ |  z  r  ¢
~
 w z z  z 
  ¢ ø ò
   ¢   P 
æ P zP  ¢ z
ø ò   P    à G and
 
î P    m
  (ˆ ‰ 4 |  G ( G
.ý
æ  / P $ .ý  
0

$ P
Now

28
 m  m  m
m |s] |~]?|U£ b b 4 4 4 4 m 4 4 ] y £ £ b
] b ì å ì  ì | | z ì z z å
ñ ñ ä  4 |¡£ 4 |¡£ 4 |¡£ yQõ ¨H©¤ª•« y z ­ yQõ ¨H©ª ä y  ]  £
4 |¡ b
z z z  '  z z
4 4 | 4 m   m  m
 ì ] ]4 ¡ | £ b y £ £ b
4 |¡£ yQõ ¨H©ª
y ] 4 | ¡ £ b z z 
z 
z z 2
z ' z
4 | 4 m  m 
 ì ] y £ b
yQõ 4 |¡£ H
¨ ¤
© ª y ] 4 ¡
| £ b z  
z 2
 m  z z
 ] a |U£ b
ñ
z 
Now

 -.
î  m ' m m  
m 4 | ( G 4 4 ] y £ b
] a 
|U£ b    ì |
z z
ñ  ñ *,
 yQõ ] 4 |¡£ b ¨H©¤ª y 4 |Å£   2
z  ( 4 | G ( 4 | G
 z z 
î mÔî  »  m 
4 354
4 ] | y ( G
 G b
 z z
 ¨H©ª21 | y 4 | G

8657
yQõ ( 4 | G

4
 

yQõ ( ] |¡£ ] | G b
4 b 4
z   
m  m    î mî    m
354
| 4 ] y £ b 4
] | G b ] | y  ( G G b ]4
z   z z  z
¨H©ª91 y :; ] 4 |¡£ b ] 4 | G b
z
4 4 § 
  ×
 ¨H©ª Õ | y ] 4 |¡£ b ] 4 | 
yQõ ( ] 4 |¡£ b ] 4 | G b G b
z z
where

     
m T     m    tî mî 
§  ]4 | b ] 4 |¡£ b V y £ ]4 |
ã b ]4 | b] 4 |¡£ b | y ] 4 |¡£ b
z r r z r z r z z r z
      
m    ^î  m  mî 
 ]4 | £ b ]4 | b ] 4 |¡£ b y £W] 4 | b | y ]4 ¡
| £ b
z r z z r z z r r z
 
To simplify the above, consider the following correlation matrix
 ->=
 =
4 |U£ ( G =
 .

*< |U£ 4 ( G £W]?| 4cb
<  
<  
, ( G ( G £ 4

29
Determinant:

     
     
y ]?|U£ b
| ?] |U£ b | £ |¡£ 4
r  r  r  r z z
   
g4 |¡£ | y £ | £
z r  z r r z

 ] 4 |¡£ b ] 4 | b
z r
Inverse:

     ->=
      =
4 |¡£ G G G ]?|U£  b |~]?|U£ b |?( G ]?|U£ b ]?|U£ b
G
( ( ( =
  
4    z    .
  *< | ( G ( G £µ~ | ]?|U£ b 4 | G ]?|U£ b ( G | ( G ]?|U£ b
] 4 |¡£ b ] 4 | G b <     
z
<      
, |?( G |™@ £  ( G ]?|U£ b ( G  |U£@(  G A | ( G ]?|U£ b |U£ 4
   ->= z
4 |™£ G  £ã] 4 |  b | G ] 4 |¡£ b .
4  z G z
  £W] 4  | G b 4 | G _
] 4 |¡£ b ] 4 | G b *< 
z
, |?( G ] 4 |¡£ b _ 4 |™£
z z
Then
  
   ->=
m -.
4 ¡ | £ G £ ]4
W |
G
 b | G ]4 ¡| £ b .
k m î £ ] 4 |
ã z b 4 | _ z
u G G
*<  *, î
 , | ( G ]4 |¡£ b _ 4 |Å£ 
 z  z   
m    î  m    m  ^î
 ] 4 |™£ G b £ ]4 | G b |
ã ( G ] 4 |¡£ b £W] 4 | G b ]4 | G b | ( G ] 4 |¡£ b ] 4 |¡£ b °
¯ m -. z  z  z z

*, î

     
m  ^m  mî  ^m   
 ] 4 |¡£ b £W] 4 | b | ] 4 |™£ b £ã] 4 | b ]4 | b
z 
z r 
r r z 
r

z r

mî tî 
| ] 4 |¡£ b ]4 ¡| £ b
z z r
z
    
m    ^  î  m  mî 
 ] 4 |¡£ b ]4 | b ] 4 |™£ b y £ã] 4 | b | y ] 4 |™£ b
z z r 
z r z z 
r r z
Thus

4 4 § 
  ¨H©¤ª Õ | y ] 4 |¡£ b ] 4 |  ×

yQõ ( ] 4 |¡£ b ] 4 | G b G b
z z

30
is the distribution function of a trivariate normal distribution with the above corre-
lation matrix. Thus
Ù ò
¢
Ç þý /
 Ç¢1ý ë
 * Ç þý ¢ ,  
' þÿ ý ë
¢1ÿ ý  Ç .
y  ‚ Ü ë ë ë .
 L
ç Q
ü ±
û ü ê ç ü ê ê û ç=üûÊü ê
¨Hò ©¤ª  2 ‰
 z P P  ->= P
é é  = é
m 4 |U£ ( G =
 .
 î¬ žm
*<
î
a :EE |UG Ÿ F&H 4 | ( G £ BJII
ñ < :;  < C D B   I
E
;
  D 
ò , ( G | ? ( G £ 4
 ->= ->=
 = ¢ =
4 |U£ ( G   
 . = 

£W]  ‚  y Ü b | Ü |  ‚ 
 .
=
 | Ü |  ‚  r |¬â Ñ ‚ r
 \ |¥£  4 a a ˆ a 
 |?( G £
*< *<
< <  r z ˆ r  
< <   
, , ( G |UK £ ( G 4    z  

where

Y
Ü BÎÏ 
« ­
‚
“
â BÎÏ 
« ­
‚

 ‚  Ÿ¬|™Ÿ  | yz

‚  Ÿ¬|™Ÿ | yz

z
z z
 Ñ ‚  ‚ |  z £  ‚
z z 
Let

w 
Z  
 r
   w 
Z  
ò r
ò  Ü
ÜÀù
 ò r
ò | y Üw
Z  
 
  
 w
Z  
 
 | Ü
ÜÀù 
 
 
31
Then
ÙHó

Ç ¢ 
ÿ ý 
4  ‚ ë  G L
M
ë ò ò
 | z r × ç û Oê ˆ ‰
¨H©¤ª Õ y «  ­
 P
é    
4 w  P ë . 
   ò ò
ç é
¿ w ç û Z  a"Z | å Z Z 
ð r ñ « z r ­
P
‰ ñ ä r
z  z
 z   z  þ ÿ ý é Ç ¢   ´
4  ‚ ë ë G M L 4 w   
 | z r × ç û O ê ˆ ‰ ç é w ç ]±Z  b ]±Z b Z Z 
¨H©¤ª Õ y «  ­ ð r ñ « z r ­ ñ ñ
 P  z   z  z P
é é
where


 í   
|  ( G Z 
#  
ˆ ‰( 4 | 
G

Now

Ç¢  
4  ‚  G L
N 4 4  ‚   ‚ 4
ë
| z rØ× O ê ˆ ‰ ±] Z  ½
b  | z r  r Z  | Z  ×
¨H©ªÖÕ y «  ­ ñ yQõ H
¨ 
© Ö
ª Õ y «  ­    y z
  '   z
4 4 
 | ]  ‚ r | y  ‚  ¥ r rZ  Z   r b 2
yQõ ¨H©ª y  r z z   z  z
 4 '  4z
 | ]  ‚  rD|~]±Z   r b†b
yQõ ¨H©ª y  r  z 2
  z
 ‚ r
 Z  |
ñ «  r ­
 
Thus
ÙHó ø ò ò

ÿ ý ´
ë  ‚ r 4 w   
 ç û ç é ç Z  | ] b Z w Z 
P
ð
P ñ «  r ­ r ñ « z r ­ ñ
   z   z  z
é é
Let

m  ‚ r
 Z  |
 r
žm   
 Z 
Ü Ü |  ‚ r
ù
 r  r
   
32
Let

' ì
4 
 | 4 |¡£ w £ ]  rZ  |  ‚  r b 2
 z W
 r z z  
 | z 4  ì 
 4 ¡
| £
 r z
ú ù  |Ìz ú 

¢ 
â)| Ñ ‚ r~| £ w
‘  ì ˆ
z 4 |¡£ ˆ ¢
z
â)| Ñ ‚ r~| £ã]  rZ  b
 ì ˆ  
z 4 ˆ |¡£ ¢
   z
|¬â Ñ ‚ r £  ‚ r
ù ˆ
z r ˆ
 z 
Let ò

   
î  ø ò    Ž_ r
 4 | Z | Z  |
r r «  r ­
   
î  
 4 | ø
r
|Ìú ù |Ìú

P í   

 ( G
#  
ˆ ‰ 
( 4 | G
 
| Ü   r
ù   ‚
  r r 
  
| Ü    ‚ 
  
  
| Ü       
‚
 
 
 
Thus
ÙHó
¢
Ç -ý /O Ç1¢ ý ë  Ç þý ǝ .   -.
± ÿ ý ¢1ÿ ëý    m î”  m
ë .
ê ë ê ë m 4 ] £ b 4 ( G žî¬ m
 ç ûÊü ê ç ü ç=üû ê ] b ì | ì å  +



P P P
‰ ñ 4 |¡£ ñ ä  4 |¡£ 4 | ñ *, 4 | G
z z
( G ( 
é é é
since

33
 ' ì
4  m
 | 4 |™£ w £ ]  r b 2
 z ã
 r z z  
æ w
 z  m 4
 | r;M|  £  r ì
«   z   ­ 4 |¡£
z z m  z
æ w | ]
s £ bò
 ì
z r  4 |Å£
 z    z  
î   m
and ò  4 | Z |
r  r
î»  m
( G
æ Z  

( 4 | G

Now

 m
m 4 |s] £ b m 
] b ì ì å  ] a |U£ b
ñ 4 |™£ ñ ä  4 |¡£ ñ
z z z 
and
 -.
î¿  m ' mm  
m 4 ( G 4 4 ] y £ b
] a 
| £ b
U    ì | z 4
ñ  ñ *,
 yQõ 4 |¡£ ¨H©¤ª y |™£   z 2
 ( 4 | G ( 4 | G
 z z  
î  mÔî  »m 
4 34
4 ] y ( G
 G b
 | z  z
 ¨H©ª21 y 4 | G 86 7
yQõ ( 4 | G

4
 
 ¨H©ª
yQõ ] 4 |¡£ b ] 4 |
( G b
z   
m  m    î  mî  » m 
354
| 4 ] y £ b ]4 | G b ] y  ( G G b ] 4 |¡£ b
z   z z  z z
1 y :; ]4 |™£ b ] 4 | G b
z
4 4 § 
  |  ×
 ¨H©ª Õ y 4] |¡£ b ] 4 | G b
yQõP( ] 4 |¡£ b ] 4 | G b
z z
where

      
m   m    ^î  mî  ^m 
§  ]4 | b y £ã] 4 | b ] 4 |¡£ b ]4 | b y ]4 ™ | £ b ] 4 |¡£ b
z r 
r 
z r z z r z z r z
     
m    ^î  m    m î 
 ]4 | £ b ]4 | b ] 4 |¡£ b y £W] 4 | b y ]4 ¡| £ b
z r z 
z r z z 
r r z

34
Then consider
 ->=
 =
4 |¥£ |?( G =
.

*< |U£ 4 £ ( G
<  
<  
, |?( G £K( G 4
Determinant:

     
     
 | y £ £ |¡£ |¡£ 4
r   r r z r z
  
g4 | £ |¡£
r r  z

 ] 4 |¡£ b ] 4 | b
z r
Inverse:

     ->=
      =
4 ¡ | £  G | G £ £ ¡
| £ G £
G G 
( ( ( ( =
z .
4       
  *< |?( G ( G £ £ 4 | G £K( G |¡£K( G
] 4 |¡£ b ] 4 | G b <<    
z    
, ( G |™£ ( G £ £ ( G |¡£ ( G 4 |¡£
   ->= z
   =
4 |™£ G  £ã] 4 | G b ( G ]4 ¡| £ b .
4  z  z
  £W]  4 | G b 4 | G _
] 4 |¡£ b ] 4 | G b *<< 
z , ( G ] 4 |¡£ b _ 4 |™£
 z   z ->=
   = m -.
4 |¡£ G  £W] 4 | G b ( G ]4 ¡| £ b .
k m î z  z
 u *< £ã]  4 | G b 4 | G _
<  *, î
 
, ( G ] 4 |¡£ b _ 4 |¡£
z z
 §
Thus
ÙHó ò
¢  ->=
Ç -ý /O Ç1¢ ý ë > Ç þý ǝ .  m -. 4 |¥£ |?(
 =
± ÿ ý ¢1ÿ ëý   G =
ë ë ë . 
.
î¬ žm
ê ê
 ç ûÊü ê ç ü ç=üû ê :E a *< |U£ 4 £@( G
BJI
I
‰ ñ E
E *,
î <   I
P P P ;
 <   D 
òé é é , | ( G £ ( G 4
 ->=
 = ¢
4 |¥£ | ( G
Q =     
 . Ü |  ‚  r |¬â Ñ ‚ r £  ‚ r | Ü
  ‚  BJI
 \ :E *< |U£ 4 £ ( G
@ a a ˆ a  I
E <    r z r ˆ   I
E <     D
; , | ( G £ ( G 4    z 

35
where

Y
Ü BÎÏ 
« ­
‚
“
â BÎÏ 
« ­
‚

 ‚  Ÿ¬|™Ÿ  | yz

‚  Ÿ¬|™Ÿ | yz

z
z z
 Ñ ‚  ‚ |  z £  ‚
ò ò
%  z z  Í
Similarly for . ¢ 
ò ó %  ³ Ò Gò F oSR ø  ¢V øí U ø ò ò ø ó ø ø
The formula is thus ŸQX# OÌ O PSR 8O Íw \ h] ] b a w  a w aw b |
 ‚ z
T
z  ˆ z
Ç
G F Oxw o R  ¢í U
\ ]†]W b a w aw aw b | “ O S
¥ P R \ †] ] b a  a a b |¥\ h] ]W b a a a b
„ z
T „
‡ I ˆ z ‡ I
where
Í  ->=
 =
4 a8|¥£aX( G =
 .

 *< |U£ a 4 a8|U£ (  G
<
<  
, ( G a8|U@ £ ( G a 4
 ->=
 =
4 a8|¥£a8|?( G =
 .

W  *< |U£a  4 a†£ ( G
<
<  
, | (
 G a†£ ( G a 4
í G
w ò  P P   
 T G ¢  ë ¢
9 G ¢ë  G í
w ó  P ˆ ‰ C
í T  G T z
w z  P P    ˆ ‰
í T G
w  Pˆ  ‰  
 G ¢  ë ¢
9T G¢ ë  G
øw  Pˆ ‰ C 
„ í T  G T
øw  P   ˆ ‰
í T ǝ G
‡ P ˆ P ‰
ø ò   G¢  ¢  
9 T Ç G ¢ ëë   Ç G í
ø ó  P ˆ ‰ C
í T ǝ   G T z
z  P P   ˆ ‰
í ǝ T G
 Pˆ  ‰
T G
ˆ ‰
36
ø
ø ¢
9

Ç¢ G  ë   Ç  G
ë
 P C ¢
„  T   G T
í Ç
 P   ˆ ‰
T
‡ ˆ ‰

4.4 Results
It is obvious from the above that deriving analytic formulae for complicated bar-
rier options is not a simple matter. Examples even slightly more complex than
the one analysed in this report may be impossible to price analytically because
of the complex distributions arising from intricate conditional probabilities. Thus
we are forced to examine numerical techniques in order to price these barrier op-
tions. Analytic solutions can, however, often be used as control variates to improve
numerical solutions.
Another drawback of an analytic solution is that often it is difficult to evaluate
because the integrals remain complex even when reduced to recognisable forms.
These integrals must be computed numerically, which can take a long time, eroding
one of the main benefits of an analytic solution. In the specific case examined here,
the trivariate normal cumulative distribution functions (cdf’s) were evaluated using
Mathematica. To value the entire formula took on average about a minute and a
half.

37
 
£  Analytic Price Analytic Price JP Morgan
-0.75 0.25 4.5958 11.49% 12.41%
0.5 4.8042 12.01% 12.67%
0.75 5.0118 12.53% 13.01%
-0.5 0.25 4.1549 10.39% 11.08%
0.5 4.3771 10.94% 11.43%
0.75 4.6339 11.58% 11.89%
-0.25 0.25 3.5844 8.96% 9.53%
0.5 3.8062 9.52% 9.90%
0.75 4.0887 10.22% 10.50%
0 0.25 2.9811 7.45% 7.84%
0.5 3.1910 7.98% 8.23%
0.75 3.4800 8.70% 8.90%
0.25 0.25 2.3540 5.89% 6.07%
0.5 2.5413 6.35% 6.44%
0.75 2.8187 7.05% 7.13%
0.5 0.25 1.7095 4.27% 4.21%
0.5 1.8637 4.66% 4.61%
0.75 2.1105 5.28% 5.27%
0.75 0.25 1.3028 2.58% 2.10%
0.5 1.1583 2.90% 2.38%
0.75 1.3507 3.38% 3.28%
 
Table 4.1:    ž_ , ŸZY  Ÿ  _ 6 _G[G\ ,   ^] __\ ,“  ž_ ,Y  [Q_ ,
Ÿ g4 _
_ \ . z   z
Ý

38
Chapter 5

Monte Carlo Pricing

Monte Carlo simulation is a technique used to solve integrals numerically. this

is appropriate to the pricing of derivatives since the price of a derivative can be
expressed as an integral. The martingale pricing formula for a derivative that has
K 
price  at time and a payoff dependent on correlated assets is
K
  G   TK
O PSR P A GV
G   5T `
 O PSR P A ]`Y G b V
` î 
 ç a ]w b ]w b w
_

` î
where ]`Y G b is a function of correlated standard Brownian motions and ] w b is
an -dimensional normal probability density function.
Crude Monte Carlo integration estimates the expected value by

bK 4   `
  ]w b (5.1)
 \ c 

î
where w a 68686 a w are independently drawn from .
This is easily scaled up to path dependent problems since a stock price can be
simulated alongc its entire path and the terminal value used to estimate the payoff.
Monte Carlo simulation is also particularly suited to problems in higher dimensions
since the order of convergence does not depend on the dimension of the problem.
It is also easy to simulate correlated stock prices by generating correlated N(0,1)
random variables using a technique such as Cholesky decomposition. This is an
attractive attribute of Monte Carlo methods since in practice rainbow barrier op-
tions tend to be vastly more complex than the problem analysed in the previous
chapter. There are, however, problems associated with Monte Carlo estimation of
barrier options, as has been mentioned in chapter 2. Suggested solutions to these
problems will be presented in this chapter.

39
5.1 Implementation
The path of the asset’s price is simulated by simulating the price at equally spaced
points. This is done by generating ô , a \»]`_a 4cb random number, at every point and
using the formula
 
    
  ] ŸÌ|  z
b d d ô (5.2)
 ¨H©ª « y   ­
 
where is the asset price at the X th point in the path and d is the interval between
evaluation or observation points.
If, in the case of a knock-out option, the simulated asset price is observed to
cross the barrier, the simulation is terminated and the payoff set to zero. If the
simulation survives to maturity, the payoff is calculated from the final simulated
asset price.
This is done \ times. The estimate is calculated using

K G   `
MO PSR (5.3)
‚ c 


`
where is the payoff from path X and r is the time to maturity of the barrier option.
In the case of an Up-and-In option, if the barrier is observed to be crossed at
any point, the path is marked as having knocked in and the payoff is calculated
from the terminal price. If the path is never marked as having knocked in, the
payoff is zero. When vectorised code is used, it is better to check the path at each
point than to store the path and check at the end because of memory limitations.
The 5.1 below compares the price estimated by this crude Monte Carlo method
for the option priced in chapter 4 to the prices generated by a model at JP Morgan
where the prices are represented as a percentage of the strike price. The crude
Monte Carlo estimate is quite good.

5.2 Removing Bias For Continuous Monitoring

As has been stated previously, the Monte Carlo estimator is biased when monitor-
ing is continuous. It underestimates the analytic solution in the case of “in” barrier
options and overestimates in the case of “out” barrier options. The underlying asset
price is observed at discrete points and the maximum or minimum of these obser-
vations is taken as the realised maximum or minimum of the asset price. However,
the maximum or minimum of the asset price is respectively greater or less than
the observed value with probability 1. Thus the asset price may have crossed the
barrier, although the observed values do not. Then the option is estimated to knock
in or out less often than the it actually would, resulting in more zero payoffs in the
case of a knock-in option and fewer when the option knocks out. This results in a
biased estimator.

40
 
£  Analytic Price Analytic Price JP Morgan
-0.75 0.25 4.7458 11.86% 12.41%
0.5 4.9437 12.36% 12.67%
0.75 5.1117 12.78% 13.01%
-0.5 0.25 4.2402 10.60% 11.08%
0.5 4.4199 11.05% 11.43%
0.75 4.7552 11.89% 11.89%
-0.25 0.25 3.5903 8.98% 9.53%
0.5 3.8954 9.74% 9.90%
0.75 4.1138 10.28% 10.50%
0 0.25 3.0107 7.53% 7.84%
0.5 3.2979 8.24% 8.23%
0.75 3.5041 8.76% 8.90%
0.25 0.25 2.3941 5.99% 6.07%
0.5 2.5967 6.49% 6.44%
0.75 2.8979 7.24% 7.13%
0.5 0.25 1.7970 4.49% 4.21%
0.5 1.9371 4.84% 4.61%
0.75 2.1543 5.39% 5.27%
0.75 0.25 1.1074 2.77% 2.10%
0.5 1.2173 3.04% 2.38%
0.75 1.4020 3.51% 3.28%
 
Table 5.1:    ž_ , Ÿ Y  Ÿ  _ 6 _G[G\ ,   ^] __\ ,“  ž_ ,Y  [Q_ ,
Ÿ g4 _
_ \ . z   z
Ý

To improve the estimate, we must get a better estimate of the extreme value of
the underlying asset price. One way to do so is to reduce the time interval between
observations, but this is not an efficient technique. A more efficient technique was
proposed by Beaglehole, Dybvig and Zhou [2] and extended by Baldi, Caramellino
and Iovino [1]. Improving the estimate is not an entirely academic exercise as there
are barrier options, especially in the currency options market, where the barrier is
monitored almost continuously.
Using the concept of a Brownian bridge, it is possible to calculate the probabil-
ity that the asset price crosses the barrier between two observed points. A Brownian
bridge is a complex mathematical construct,
T but Karatzas and Shreve [11] describe
a  Brownian bridge from ‘ to Ü on _a1rUV simply as a Brownian motion started at ‘
  
and conditioned to arrive at Ü at time r . By constructing a Brownian bridge from
     
to  over ] a  b , we can find the probability that the barrier is crossed
on the interval by deriving the probability that the maximum or minimum of the
Brownian bridge is above or below the barrier, depending on whether we are pric-
ing an “up” or a “down” barrier option. The probability of crossing the barrier is

41
 Sample Size Crude Importance Sampling Improvement
1000 0.00019044 0.00008100 57.47%
2000 0.00094864 0.00018225 80.79%
3000 0.00096100 0.00005625 94.15%
4000 0.00055225 0.00002809 94.91%
5000 0.00038809 0.00002401 93.81%

Table 5.2: Squared Deviations of Estimates

stated by Baldi, Caramellino and Iovino as

 
  '
% ß ‘ w  o y   
]     –~Y b½{O8w |  ] e Y}|e b ]e Y |e  b (5.4)
] a  b d 2
 z
in the case of an “out” option and
 
  '
% èX  o y   
]     –~Y b½{O8w |  ] e |e Y b ]e  |e Y b (5.5)
] a  b d 2
 z  
for an “in” option.
  
The method for implementing the technique is to generate and  as usual
o
and then to calculate the probability ] b of the asset price crossing the barrier given
these two points and using the above formulae. The option is then knocked out
o o
with probability and survives with probability 4 | in the case of a knock-out
² m
barrier. This can be simulated by generating a ]`_a 4cb random number ] b and
o m o m o
comparing it to . Knock-out if ¼ and continue if – .
The table and graphs below show the reduction in bias that results from apply-

ing this method. 5.1, 5.2, 5.3 and 5.2 all use parameters È4 __ , f  ] _
_ \ ,
‚ 
“  C g _ ,Ÿ  4 _ \ ,Y
_  4 _ [ and r
G  4 . The reductio nin bias becomes quite
dramatic ehen the number of observation points is reduced. 5.2 shows that when
this method is applied, better results can be acheived by using fewer observation
points. 5.4 graphs estimates of a rainbow up-and-out call shows that the method
improves estimates for rainbow barrier options as well.

5.3 Variance Reduction

Monte Carlo estimation of “out” barrier options suffers from an additional defect.
Some of the paths survive and contribute to the estimation of the positive terminal
payoffs, others do not survive and have payoff zero. This results in a variance over
all paths that is quite large relative to the price. Glasserman and Staum [8] have
developed a variance reduction method to deal with this problem. This method will
be discussed in this section.
The traditional approach to reducing the variance of a Monte Carlo estimate
when the sampling distribution is not suited to the function to be integrated, is
importance sampling. A new distribution that is a better match is chosen and the

42
 0.2

Analytic Continuous
Crude
0.18 Adjusted

0.16

0.14

0.12

0.1

0.08

0.06
0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000

Figure 5.1: Estimate vs Sample Size. 365 observation points

0.3

Analytic Continuous
Crude
Adjusted
0.25

0.2

0.15

0.1

0.05
0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000

Figure 5.2: Estimate vs Sample Size. 50 observation points

43
 0.18

Analytic
0.16 Crude (365)
Adjusted (50)
0.14

0.12

0.1

0.08

0.06

0.04

0.02

0
0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000

Figure 5.3: Estimate vs Sample Size. 365 observation points for the Crude estimate
and 50 observation points for the Brownian Bridge estimate

1.6

Analytic
1.5 Crude
Adjusted
1.4

1.3

1.2

1.1

0.9

0.8

0.7
0 5 10 15 20 25

Figure 5.4: Estimate vs Sample Size. Rainbow up-and-out call. 365 observation
points

44
estimate is adjusted to sampling from this new distribution. To improve variance in
the case of “out” barrier options it would be necessary to use the conditional dis-
tribution of the stock-price given survival to maturity. It is not possible, however,
to sample an entire path conditional on final survival. Glasserman and Staum over-
come this by suggesting an alternative method of ensuring that all paths survive
and yield information about potentially positive payoffs. Instead of conditioning
on final survival, the conditional distribution given one step survival is used. This
method is discussed below in the context of an up-and-out call.
It is assumed that the underlying stock price follows the stochastic differential
equation 
 ž 
  Y  (5.6)
 
under the martingale measure and where Y  is a standard Brownian motion. Thus,
by Ito’s lemma
  o k  
  O8w ] | yz b Y u 6 (5.7)
‚  
Which gives the discretisation
 
   o k  
  O8w ] |  y z b
d d ôu
  
 o k  h  ²
 O8w ] |  y z b
d d P ] bu
 
²
where
T ô is drawn from the \^]`_a 4cb distribution and is distributed uniformly over
_a 4 V .
Let   
o %   
]ji b   f~Ylk b
 ] 
%  o k  
  
 O8w ]  |  z
b d d ôuÒfDYmk
« y ¢   ­
on

h   ] | bd


 ]e ] Y b ˆ  å
ä zd
 
To ensure survival to the next step, we must generate a random variable uni-
formly distributed conditional on being at least as small as necessary to prevent
knock-out. To do so, we  must note the following
 
 ¼  Y
 o k  h  ²
qp Oxw ] |  y z b
d d P ¢ ] bu ¼ Y
on   
² h k    | b
d
qp ¼ | ]e ] Y b ˆ  u å
 ä zd
o   
g4 | ] b"6

45
 
Thus, to ensure one-step survival, we must generate a uniform random variable on
o  ²
]`_a 4 | ] b†b . This is accomplished by generating
 ; [ ]`_a 4cb and setting
² o 
 ]4 | ] b†b ; (5.8)
²
By generating at each step and thus calculating the stock price conditional on
surviving the step using
 
    rh  ²
  ]†]  |  z
b d d P ] b†b a (5.9)
¨H©ª y  
we have ensured that all paths survive to maturity and contribute to the estimation
of the payoff.
If the option price were estimated merely from these payoffs, the estimate
would be severely biased because of the absence of paths which get knocked out.
To compensate for this, each estimate of the terminal payoff is multiplied by a
likelihood ratio. This likelihood ratio is defined by
 
s   t P o 
 ]4 | ] b†b (5.10)

‚
where  is the number of observations along the path. Thus, when we multiply the
estimate of the payoff by the likelihood ratio, we are multiplying by the probability
that the path survives to maturity.
Glasserman and Staum [8] prove that the new estimator is unbiased and that
the variance of the new estimator is below that of the crude Monte Carlo estimator.
The improvement in variance that this technique offers must be weighed against
²
the extended time that it takes to generate the estimates. Not only must the ’s be
generated and inverse normal cdf’s be calculated, but every path must be simulated
to maturity, whereas a crude Monte Carlo would cease calculating paths that do
not survive. It is only in cases where there is a high probability of knock-out that
the method is truly effective, as highlighted by Glasserman and Staum [8] and
demonstrated by the examples that follow.
There is a suggested adaptation of this method to the continuous case, but it is
cumbersome and the method is better suited to the discrete case.

?? uses parameters ›4 __ , u ] _
_ \ ,“ v g _ , Y 34 G
_ [ , Ÿ ›4 __ \ and
‚ 
r L
 4 . ?? and 5.3 use the same parameters but change the barrier to Y L
 4 _ y to
increase the probability of knock-out. ?? uses a volatility of x  w __ \ for the same
reason. The graphs show that importance sampling improves  convergence in all
cases but that this is especially pronounced for the cases in which there is a greated
chance of knock-out.

46
Sample Size Crude Importance Sampling Improvement
1000 0.000084388 0.000056334 33.25%
2000 0.000046605 0.000047300 -1.49%
3000 0.000062619 0.000026709 57.35%
4000 0.000071263 0.000019486 72.66%
5000 0.000047236 0.000018747 60.31%

Table 5.3: Squared Deviations of Estimates

0.13

Analytic Continuous
0.12 Analytic Discrete
Crude
Importance Sampling
0.11

0.1

0.09

0.08

0.07

0.06
0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000

Figure 5.5: Estimate vs Sample Size.

47
 0.05

Analytic Continuous
0.045
Analytic Discrete
Crude
0.04 Importance Sampling

0.035

0.03

0.025

0.02

0.015

0.01

0.005

0
0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000

Figure 5.6: Estimate vs Sample Size.

0.05

Analytic Continuous
0.045
Analytic Discrete
Crude
0.04 Importance Sampling

0.035

0.03

0.025

0.02

0.015

0.01

0.005

0
0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000

Figure 5.7: Estimate vs Sample Size.

48
Chapter 6

Practical Example

An example of how a non-standard barrier option can be used in practice is useful

to illustrate the advantages of using non-standard barrier options.

Example
Company A holds a stake in Company B which it would like to
dispose of. The proceeds of such a sale would be used to acquire
an interest in Company C. However, “A” expects “B” to shortly
announce strong year-end results which it believes will have a
positive impact on “B”’s share price. So “A” is only a seller of
“B” if its share price reaches X (higher than today’s value) but
would like to lock in today’s price of “C” (equal to Y).
“A” could therefore buy an up-and-in call which knocks in if “B”’s
share price hits X and which pays out ’‘ w (0, “C”- Y)
If “A” is restricted from selling “B” for some time due to, say, a
lock-in agreement then “A” could cheapen the cost of the option by
modifying it to contain only partial monitoring (beginning after the
lock-in period expires).
Í
The table below shows the price of the barrier option where “B”=“C”=40,
Ÿ  XŸ y  [G\ , Ÿ É4 __ \ ,  [Q_ and W  ž_ .
Ý 
£  Price
-0.5 0.25 1.1826
0.5 1.0246
0.75 0.7776
0 0.25 2.3040
0.5 2.1179
0.75 2.0009
0.5 0.25 3.6119
0.5 3.5743
0.75 3.4725

49
 The example was intended to illustrate how barrier options can be usee to hedge
a position given certain parameters. In reality these parameters would not remain
constant over various strike prices or barrier levels when pricing the option. The
log-normal model assumed in pricing models does not hold in practice. The tails
of the actual distribution are much thicker. Thus, when an option is priced, the
volatility is adjusted according to strike price and, in the case of barrier options,
barrier level. This results in a surface of volatilities over strike price and barrier
level called the “skew”. To find an appropriate volatility to price a barrier option,
it is necessary to interpolate across the skew.
Another assumption that does not hold in practice is that of a constant dividend
yield across all asset levels. The dividend yield is estimated as a function of the as-
set level. Dividends are not paid continuously, the dividend estimated by the trader
is expected to remain the same despite changes in the asset level. The dividend
yield will thus change as the asset level changes. In addition, the risk free rate is
not assumed to be constant but is assumed to follow a term structure pulled from
the yield curve.

50
Chapter 7

Conclusion

The objective of the research was to price non-standard barrier options as defined
in chapter 1. This was accomplished by means of deriving analytic formulae and
through the use of Monte Carlo estimation. Each method has its advantages and
disadvantages.
An analytical formula was derived for a very specific barrier option. Although
it was a simple example of a rainbow barrier option, it was difficult to solve because
of the dependencies between the assets and between the barrier asset at different
time-points. This complexity is the great disadvantage of analytic pricing. The
advantage of an analytic formula is that it is quick to price an option once it has
been derived. As we have seen, this advantage is somewhat reduced in the case
of complex barrier options since the formula itself is complex enough to warrant
numerical integration.
An analytic formula is not to be seen as a way of finding the correct and indis-
putable price of an option. It reduces the assumptions that the trader must make,
but he or she must still use discretion in setting the parameters. Thus, a good
numerical solution can be as useful as an analytical solution.
Monte Carlo integration is slow. This is its main negative attribute, but it makes
up for it by being incredibly flexible. It is exceptionally easy to generate correlated
stock prices using correlated normal random variables and, as has been demon-
strated, extending the basic technique to path dependent problems is not difficult.
First crude Monte Carlo estimates were used to find prices for barrier options.
These worked well in the when monitoring was discrete but produced biased esti-
mates for continuously monitored barrier options. To reduce this bias, a technique
using the concept of a Brownian bridge to more accurately model knock-out was
investigated. This produced estimaes that were closer to the analytic prices in all
cases. Better results were produced even when the number of observation points
used in the Brownian bridge estimate was well below the number of observation
points used in the crude estimate.
Another improvment to Monte Carlo estimation was the use of importance
sampling as a variance reduction measure. It was found that the estimate could be

51
greatly improved by using this technique. This technique was, however, only really
effective when the probability of knock-out was high due to the increased run-time
of the method.

52
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[14] M. Rubenstein and E. Reiner. Breaking down the barriers. RISK, September
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54