Chapter 11

Barrier Options

Barrier options are financial derivatives whose payoffs depend on the crossing
of a certain predefined barrier level by the underlying asset price process
(St )t∈[0,T ] . In this chapter, we consider barrier options whose payoffs depend
on an extremum of (St )t∈[0,T ] , in addition to the terminal value ST . Barrier
options are then priced by computing the discounted expected values of their
claim payoffs, or by PDE arguments.

11.1 Options on Extrema . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407

11.2 Knock-Out Barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412
11.3 Knock-In Barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424
11.4 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427
11.5 Hedging Barrier Options . . . . . . . . . . . . . . . . . . . . . . . 431
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432

11.1 Options on Extrema

Vanilla options with payoff C = ϕ(ST ) can be priced as

w∞
e −rT E∗ [ϕ(ST )] = e −rT ϕ(y )φST (y )dy
0

where φST (y ) is the (one parameter) probability density function of ST , which

satisfies wy
P(ST ⩽ y ) = φST (v )dv, y > 0.
0
Recall that typically we have

if x ⩾ K,

x−K
ϕ(x) = (x − K ) + =
0 if x < K,


for the European call option with strike price K, and

" 407
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

 $1 if x ⩾ K,


ϕ(x) = 1[K,∞) (x) =

0 if x < K,


for the binary call option with strike price K. On the other hand, exotic
options, also called path-dependent options, are options whose payoff C may
depend on the whole path

{St : 0 ⩽ t ⩽ T }

of the underlying asset price process via a “complex” operation such as aver-
aging or computing a maximum. They are opposed to vanilla options whose
payoff
C = ϕ(ST ),
depends only on the terminal value ST of the price process via a payoff
function ϕ, and can be priced by the computation of path integrals, see Sec-
tion 17.3.
For example, the payoff of an option on extrema may take the form

C := ϕ M0T , ST ,

where
M0T = Max St
t∈[0,T ]

is the maximum of (St )t∈R+ over the time interval [0, T ]. In such situations
the option price at time t = 0 can be expressed as
w∞w∞
e −rT E∗ ϕ M0T , ST = e −rT


ϕ(x, y )φM T ,ST (x, y )dxdy
0 0 0

where φM T ,ST is the joint probability density function of (M0T , ST ), which

0
satisfies
wxwy
P(M0T ⩽ x and ST ⩽ y ) = φM T ,ST (u, v )dudv, x, y ⩾ 0.
0 0 0

General case

Using the joint probability density function of W

fT = WT + µT and

b0T = Max W
X f = Max (Wt + µt),
t∈[0,T ] t∈[0,T ]

see Proposition 10.2, we are able to price any exotic option with payoff
ϕ(WfT , X
b T ), as
0
e −(T −t)r E∗ ϕ X
bT , W
fT Ft ,


0

408 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

with in particular, letting a ∨ b := Max(a, b),

w∞ w∞
e −rT E∗ ϕ X fT = e −rT
bT , W ϕ(x, y )dP∗ X fT ⩽ y .
b T ⩽ x, W



0 0
−∞ y∨0

In this chapter, we work in a (continuous) geometric Brownian model, in

which the asset price (St )t∈[0,T ] has the dynamics

dSt = rSt dt + σSt dWt , t ⩾ 0,

where σ > 0 and (Wt )t∈R+ is a standard Brownian motion under the risk-
neutral probability measure P∗ . In particular, by Lemma 5.14 the value Vt
of a self-financing portfolio satisfies
wT
VT e −rT = V0 + σ ξt St e −rt dWt , t ∈ [0, T ].
0

In order to price barrier∗ options by the above probabilistic method, we will

use the probability density function of the maximum

M0T = Max St
t∈[0,T ]

of geometric Brownian motion (St )t∈R+ over a given time interval [0, T ] and
the joint probability density function φM T ,ST (u, v ) derived in Chapter 10 by
0
the reflection principle.
Proposition 11.1. An exotic option with integrable claim payoff of the form
 
C = ϕ M0T , ST = ϕ Max St , ST


t∈[0,T ]

can be priced at time t = 0 as

e −rT E∗ [C ]
e −rT 2 w ∞ w ∞
r
2 2
ϕ S0 e σy , S0 e σx (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy


= 3/2
T π 0 y
e −rT 2 0 w ∞
r w
2 2
ϕ S0 e σy , S0 e σx (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy.


+ 3/2
T π −∞ 0
Proof. We have
2 T /2+rT
ST = S0 e σWT −σ = S0 e (WT +µT )σ = S0 e σW ,
eT

with
∗
“A former MBA student in finance told me on March 26, 2004, that she did not
understand why I covered barrier options until she started working in a bank” Lyuu
(2021).

" 409
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

σ r
µ := − + and W
fT = WT + µT ,
2 σ
and
2 t/2+rt
M0T = Max St = S0 Max e σWt −σ
t∈[0,T ] t∈[0,T ]

= S0 Max e σW
et
= S0 e σ Maxt∈[0,T ] Wt
e
t∈[0,T ]
T
= S0 e σXb0 ,

since σ > 0. Hence,

2 bT

C = ϕ ST , M0T = ϕ S0 e σWT −σ T /2+rT , M0T = ϕ S0 e σWT , S0 e σX0 ,


e

and

bT

e −rT E∗ [C ] = e −rT E∗ ϕ S0 e σWT , S0 e σX0
 e
w∞ w∞
= e −rT ϕ S0 e σy , S0 e σx dP X b T ⩽ x, W



fT ⩽ y
0
−∞ y∨0
e −rT 2 w ∞ w ∞
r
2 2
ϕ S0 e σy , S0 e σx (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy


= 3/2
T π −∞ y∨0
e −rT 2 w ∞ w ∞
r
2 2
ϕ S0 e σy , S0 e σx (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy


= 3/2
T π 0 y
e −rT 1 2 w 0 w ∞
r
2 2
ϕ S0 e σy , S0 e σx (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy.


+ 3/2
T π −∞ 0
□

Pricing barrier options

The payoff of an up-and-out barrier put option on the underlying asset price
St with exercise date T , strike price K and barrier level (or call level) B is

(K − ST )+ if Max St < B,


0⩽t⩽T


C = (K − ST ) 1+ n o =
Max St < B 0

 if Max St ⩾ B.
0⩽t⩽T 0⩽t⩽T

This option is also called a Callable Bear Contract, or a Bear CBBC with no
residual value, or a turbo warrant with no rebate, in which the call level B
usually satisfies B ⩽ K.
The payoff of a down-and-out barrier call option on the underlying asset price
St with exercise date T , strike price K and barrier level B is

410 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

if min St > B,

+
 (ST − K )

 0⩽t⩽T
C = (ST − K )+ 1n o=
min St > B 0

 if min St ⩽ B.
0⩽t⩽T 0⩽t⩽T

This option is also called a Callable Bull Contract, or a Bull CBBC with no
residual value, or a turbo warrant with no rebate, in which the call level B
usually satisfies B ⩾ K. ∗
Category ’R’ Callable Bull/Bear Contracts, or CBBCs, also called turbo
warrants, involve a rebate or residual value computed as the payoff of a
down-and-in lookback option. Category ’N’ Callable Bull/Bear Contracts do
not involve a residual value or rebate, and they usually satisfy B = K. See
Eriksson and Persson (2006), Wong and Chan (2008) and Exercise 11.2 for
the pricing of Category ’R’ CBBCs with rebate.

Option type CBBC Behavior Payoff Price Figure

down-and-out (ST − K )+ 1n o B ⩽ K (11.10) 11.4a
Bull min St > B
(knock-out) 0⩽t⩽T B ⩾ K (11.11) 11.4b
down-and-in (ST − K )+ 1n o B ⩽ K (11.13) 11.7a
min St < B
(knock-in) 0⩽t⩽T B ⩾ K (11.14) 11.7b
Barrier call
up-and-out (ST − K ) 1n
+ o B⩽K 0 N.A.
Max St < B
(knock-out) 0⩽t⩽T B ⩾ K (11.5) 11.1
up-and-in (ST − K )+ 1n o B ⩽ K BSCall 6.4
Max St > B
(knock-in) 0⩽t⩽T B ⩾ K (11.15) 11.8
down-and-out (K − ST )+ 1n o B ⩽ K (11.12) 11.6
min St > B
(knock-out) 0⩽t⩽T B⩾K 0 N.A.
down-and-in (K − ST )+ 1n o B ⩽ K (11.16) 11.9
min St < B
(knock-in) 0⩽t⩽T B ⩾ K BSPut 6.11
Barrier put
up-and-out (K − ST ) 1n
+ o B ⩽ K (11.8) 11.2a
Bear Max St < B
(knock-out) 0⩽t⩽T B ⩾ K (11.9) 11.2b
up-and-in (K − ST ) 1n
+ o B ⩽ K (11.17) 11.10a
Max St > B
(knock-in) 0⩽t⩽T B ⩾ K (11.18) 11.10b

Table 11.1: Barrier option types.

We can distinguish between eight different variations on barrier options, ac-

cording to Table 11.1.
∗
Download this code for the pricing of Bull CBBCs (down-and-out barrier call
options) with B ⩾ K (right-click to save as attachment).

" 411
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

In-out parity

We have the following parity relations between the prices of barrier options
and vanilla call and put options:


 Cup-in (t) + Cup-out (t) = e −(T −t)r E∗ [(ST − K )+ | Ft ], (11.1)






−(T −t)r ∗
 down-in (t) + Cdown-out (t) = e E [(ST − K )+ | Ft ], (11.2)

C



−(T −t)r ∗
 Pup-in (t) + Pup-out (t) = e E [(K − ST )+ | Ft ], (11.3)









Pdown-in (t) + Pdown-out (t) = e −(T −t)r E∗ [(K − ST )+ | Ft ], (11.4)


where the price of the European call, resp. put option with strike price K are
obtained from the Black-Scholes formula. Consequently, in what follows we
will only compute the prices of the up-and-out barrier call and put options
and of the down-and-out barrier call and put options.
Note that all knock-out barrier option prices vanish when M0t > B or mt0 < B,
while the barrier up-and-out call, resp. the down-and-out barrier put option
prices require B > K, resp. B < K, in order not to vanish.

11.2 Knock-Out Barrier

Up-and-out barrier call option

Let us consider an up-and-out barrier call option with maturity T , strike

price K, barrier (or call level) B, and payoff

 ST − K if 0Max

 St ⩽ B,
 ⩽t⩽T
C = (ST − K ) 1+ n o =
Max St < B 0

 if Max St > B,
0⩽t⩽T 0⩽t⩽T

with B ⩾ K.

Proposition 11.2. When K ⩽ B, the price

 
 +
S
e 1 M t <B E  x T −t − K 1n
−(T −t)r  ∗
Su o
S0

0 x Max <B
0⩽u⩽T −t S0 x = St

of the up-and-out barrier call option with maturity T , strike price K and
barrier level B is given by

412 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

h i
e −(T −t)r E∗ (ST − K )+ 1 T Ft (11.5)
M0 <B
(      
T −t St T −t St
= St 1 t Φ δ+ − Φ δ+
M0 <B K B
 1+2r/σ2    2     )
B T −t B T −t B
− Φ δ+ − Φ δ+
St KSt St
(      
T −t St T −t St
− e −(T −t)r K 1 t Φ δ− − Φ δ−
M0 <B K B
 1−2r/σ2    2     )
St T −t B T −t B
− Φ δ− − Φ δ− ,
B KSt St

where
1 σ2
   
τ
δ± (s) = √ log s + r ± τ , s > 0. (11.6)
σ τ 2
The price of the up-and-out barrier call option vanishes when B ⩽ K.
We also have
h i
e −(T −t)r E∗ (ST − K )+ 1 Ft
M0T <B
  
T −t St
= 1 Bl(St , K, r, T − t, σ ) − St 1
Φ δ+
M0t <B M0t <BB
 2r/σ2   2     !
B B B
−B 1M t <B Φ δ+T −t − Φ δ+ T −t
St 0 KSt St
  
T −t St
+ e −(T −t)r K 1 t Φ δ−
M0 <B B
 1−2r/σ2   2     !
S B B
+e −(T −t)r
K
t
1 M t <B Φ δ−
 T −t
− Φ δ−T −t
.
B 0 KSt St

The following code implements the up-and-out pricing formula (11.5).

" 413
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

dp <- function( T , r, v, s ) { ( log(s) + ( r + v*v/2.0)*T )/v/sqrt(T) }

dm <- function( T , r , v, s ) { ( log(s) + ( r - v*v/2.0)*T )/v/sqrt(T) }
ind<-function(condition) ifelse(condition,1,0)
CBBC <- function(S,K,B,T,r,sig){ S*ind(S<B)*(pnorm(dp(T,r,sig,S/K))
-pnorm(dp(T,r,sig,S/B)) -(B/S)**(1+2*r/sig**2)*(pnorm(dp(T,r,sig,B**2/K/S))
-pnorm(dp(T,r,sig,B/S)))) -K*exp(-r*T)*ind(S<B)*((pnorm(dm(T,r,sig,S/K))
-pnorm(dm(T,r,sig,S/B))) -(S/B)**(1-2*r/sig**2)*(pnorm(dm(T,r,sig,B**2/K/S))
-pnorm(dm(T,r,sig,B/S))))}
CBBC(S=90,K=100,B=120,T=1,r=0.01,sig=0.1)
library(devtools);
install_github("https://github.com/cran/fOptions")
install_github("https://github.com/cran/fExoticOptions")
library(fExoticOptions);StandardBarrierOption("cuo",90,100,120,0,1,0.01,0.01,0.1)

Note that taking B = +∞ in the above identity (11.5) recovers the Black-
Scholes formula
     
T −t St T −t St
e −(T −t)r E∗ [(ST − K )+ | Ft ] = St Φ δ+ − e −(T −t)r KΦ δ−
K K

for the price of European call options.

The graph of Figure 11.1 represents the up-and-out barrier call option
price given the value St of the underlying asset and the time t ∈ [0, T ] with
T = 220 days.

16
14
12
10
8
6
4
200
2
160 Time in days
0
50 60 120
70 80
Underlying
90

Fig. 11.1: Graph of the up-and-out call option price with B = 80 > K = 65.∗

Proof of Proposition 11.2. We have C = ϕ ST , M0T with

 (x − K )+ if y < B,


ϕ(x, y ) = (x − K ) 1{y<B} =
+

0 if y ⩾ B,


hence
h i
e −(T −t)r E∗ (ST − K )+ 1 Ft
M0T <B

∗
Right-click on the figure for interaction and “Full Screen Multimedia” view.

414 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

h i
= e −(T −t)r E∗ (ST − K )+ 1 t 1 
T Ft
M0 <B Mt <B
" #
= e 1 M t <B E (ST − K ) 1
−(T −t)r  ∗ + n o Ft
0 Max Sr < B
t⩽r⩽T
" + #
ST
= e −(T −t)r 1 t E∗ x −K 1 n Sr o
M0 <B St x Max > B x = St
t⩽r⩽T St
" + #
ST −t
= e −(T −t)r 1 t E∗ x −K 1 n Sr o
M0 <B S0 x Max < B x = St
0⩽r⩽T −t S0
" #
 +
= e −(T −t)r 1 t E∗ x e σWT −t − K
e
1 n o .
M0 <B x Max e σWr < B x=S
e
0⩽r⩽T −t t

It then suffices to compute, using (10.11),

h i
E∗ (ST − K )+ 1 T
M0 <B
" #
= E∗ S0 e σW − K 1 σ W 1
eT

S0 e eT >K
 bT
σX
S0 e 0 <B
w∞ w∞
S0 e σy − K 1{S0 e σy >K} 1{S0 e σx <B} dP X b T ⩽ x, W



= 0
fT ⩽ y
−∞ −∞
w∞ w∞
S0 e σy − K 1{σy>log(K/S0 )} 1{σx<log(B/S0 )} φX


= e T (x, y )dxdy
bT ,W
−∞ −∞
w∞ w∞
S0 e − K 1{σy>log(K/S0 )} 1{σx<log(B/S0 )} 1{y∨0<x} φX
σy


= bT ,We T (x, y )dxdy
−∞ −∞
r w
1 2 σ−1 log(B/S0 )
= 3/2
T π σ−1 log(K/S0 )
w σ−1 log(B/S0 ) 2 2
S0 e σy − K (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy


y∨0

e −µ T /2 2 w σ−1 log(B/S0 )
2 r
2
= (S0 e σy − K ) e µy−y /(2T )
T 3/2 π σ−1 log(K/S0 )
w σ−1 log(B/S0 )
× (2x − y ) e 2x(y−x)/T dxdy,
y∨0

if B ⩾ K and B ⩾ S0 (otherwise the option price is 0), with µ := r/σ − σ/2

and y ∨ 0 = Max(y, 0). Letting a := y ∨ 0 and b := σ −1 log(B/S0 ), we have
wb wb
(2x − y ) e 2x(y−x)/T dx = (2x − y ) e 2x(y−x)/T dx
a a
T h 2x(y−x)/T ix=b
=− e
2 x=a

" 415
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

T 2a(y−a)/T
= (e − e 2b(y−b)/T )
2
T
= ( e 2(y∨0)(y−y∨0)/T − e 2b(y−b)/T )
2
T
= (1 − e 2b(y−b)/T ),
2
hence, letting c := σ −1 log(K/S0 ), we obtain
h i
E∗ (ST − K )+ 1 T
M0 <B

e −µ T /2 w b
2
2
= √ (S0 e σy − K ) e µy−y /(2T ) (1 − e 2b(y−b)/T )dy
2πT c
2 1 w b (σ +µ)y−y2 /(2T )
= S0 e −µ T /2 √ e (1 − e 2b(y−b)/T )dy
2πT c
2 1 w b µy−y2 /(2T )
−K e −µ T /2 √ e (1 − e 2b(y−b)/T )dy
2πT c
2 1 w b (σ +µ)y−y2 /(2T )
= S0 e −µ T /2 √ e dy
2πT c
2 2 1 w b 2
−S0 e −µ T /2−2b /T √ e (σ +µ+2b/T )y−y /(2T ) dy
2πT c
2 1 w b µy−y2 /(2T )
−K e −µ T /2 √ e dy
2πT c
2 2 1 w b (µ+2b/T )y−y 2 /(2T )
+K e −µ T /2−2b /T √ e dy.
2πT c
Using Relation (10.23), we find
h i
e −rT E∗ (ST − K )+ 1 T
M0 <B
    
2 2 −c + (σ + µ)T −b + (σ + µ)T
= S0 e −(r +µ /2)T +(σ +µ) T /2 Φ √ −Φ √
T T
2 2 2
−S0 e −(r +µ /2)T −2b /T +(σ +µ+2b/T ) T /2
−c + (σ + µ + 2b/T )T −b + (σ + µ + 2b/T )T
    
× Φ √ −Φ √
T T
    
−rT −c + µT −b + µT
−K e Φ √ −Φ √
T T
2 2 2
+K e −(r +µ /2)T −2b /T +(µ+2b/T ) T /2
−c + (µ + 2b/T )T −b + (µ + 2b/T )T
    
× Φ √ −Φ √
T T
      
S0 S0
= S0 Φ δ+ T
− Φ δ+ T
K B

416 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

   2    
2 2 2 B B
−S0 e −(r +µ /2)T −2b /T +(σ +µ+2b/T ) T /2 Φ δ+
T
− Φ δ+
T
KS0 S0
      
S0 S0
−K e −rT Φ δ− T
− Φ δ− T
K B
   2    
2 2 2 B B
+K e −(r +µ /2)T −2b T +(µ+2b/T ) T /2 Φ δ− − Φ δ− ,
KS0 S0

0 ⩽ x ⩽ B, where δ±
T (s) is defined in (11.6). Given the relations

µ2 b2 T 2b 2 2r
    r  
σ B
−T r+ −2 + σ+µ+ = 2b + = 1 + 2 log ,
2 T 2 T σ 2 σ S0

and

µ2 b2 T 2b 2 2r
     
B
−T r+ −2 + µ+ = −rT + 2µb = −rT + −1 + 2 log ,
2 T 2 T σ S0

this yields
h i
e −rT E∗ (ST − K )+ 1 T (11.7)
M0 <B
      
S0 S0
= S0 Φ δ+ T
− Φ δ+ T
K B
      
S0 S0
− e −rT K Φ δ− T
− Φ δ−T
K B
 2r/σ2    2    
B B B
−B Φ δ+ T
− Φ δ+
T
S0 KS0 S0
 1−2r/σ2    2    
S0 B B
+ e −rT K Φ δ− T
− Φ δ− T
B KS0 S0
      
S0 S0
= S0 Φ δ+ T
− Φ δ+ T
K B
 1+2r/σ2    2    
B B B
−S0 Φ δ+ T
− Φ δ+T
S0 KS0 S0
      
S0 S0
− e −rT K Φ δ− T
− Φ δ−T
K B
 1−2r/σ2    2    
S0 B B
+ e −rT K Φ δ− T
− Φ δ− T
,
B KS0 S0

and this yields the result of Proposition 11.2, cf. § 7.3.3 pages 304-307 of
Shreve (2004) for a different approach to this calculation. This concludes the
proof of Proposition 11.2. □

" 417
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

Up-and-out barrier put option

This option is also called a Callable Bear Contract, or a Bear CBBC with no
residual value, or a turbo warrant with no rebate, in which B denotes the
call level∗ . The price
 
 +
S
e −(T −t)r 1 t 1n
T −t
E∗  K − x
 o
M0 <B S0 Sr 
x Max <B
0⩽r⩽T −t S0 x = St

of the up-and-out barrier put option with maturity T , strike price K and
barrier level B is given, if B ⩽ K, by
h i
e −(T −t)r E∗ (K − ST )+ 1 Ft
M0T <B
 
  1+2r/σ2    !
St B B
= St 1 T −t
Φ δ+ − 1 − Φ δ T −t
+ − 1
M0t <B B St St
    1−2r/σ2    !
T −t St St B
− e −(T −t)r K 1 t Φ δ− −1− Φ δ− T −t
−1
M0 <B B B St
    1+2r/σ2   !
T −t St B B
= St 1 t −Φ −δ+ + Φ −δ+ T −t
M0 <B B St St
− K e −(T −t)r
    1−2r/σ2   !
T −t St St B
× 1 −Φ −δ− + T −t
Φ −δ− .
M0t <B B B St
(11.8)

and, if B ⩾ K, by
h i
e −(T −t)r E∗ (K − ST )+ 1 Ft
M0T <B
    1+2r/σ2   2  !
T −t St B B
= St 1 Φ δ+ −1− T −t
Φ δ+ −1
M0t <B K St KSt
− e −(T −t)r K
    1−2r/σ2    2  !
T −t St St B
× 1 Φ δ− −1− T −t
Φ δ− −1
M0t <B K B KSt

∗
Download this code for the pricing of Bear CBBCs (up-and-out barrier put options)
with B ⩽ K (right-click to save as attachment).

418 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

    1+2r/σ2   2 !
T −t St B B
= St 1 −Φ −δ+ + T −t
Φ −δ+
M0t <B K St KSt
− K e −(T −t)r
    1−2r/σ2   2 !
T −t St St B
× 1 −Φ −δ− + Φ −δ− T −t
,
M0t <B K B KSt
" + #
S
= e −(T −t)r E∗ K − x T −t 1n Sr o
S0 x Max < B x = St
0⩽r⩽T −t S0
    1+2r/σ2   2 
S B B
= −St 1 t + St 1 t
T −t t T −t
Φ −δ+ Φ −δ+
M0 <B K M0 <B St KSt
    1−2r/σ2   2 
T −t St St B
+ K 1 t e −(T −t)r Φ −δ− − K e −(T −t)r Φ −δ− T −t
M0 <B K B KSt
 1+2r/σ2   2 
B B
= 1 t Blput (St , K, r, T − t, σ ) + St 1 t Φ −δ+ T −t
M0 <B M0 <B St KSt
 1−2r/σ2   2 
St B
− K 1 t e −(T −t)r Φ −δ− T −t
. (11.9)
M0 <B B KSt

50 12

40 10
8
30
6
20
4
10 200 2 200
160 Time in days 160 Time in days
0 0
50 60 120 50 60 120
70 80 70 80
Underlying
90 Underlying
90

(a) Case K = 100 > B = 80. (b) Case B = 80 > K = 60.

Fig. 11.2: Graphs of the up-and-out put option prices (11.8)-(11.9).

The following Figure 11.3 shows the market pricing data of an up-and-out
barrier put option on BHP Billiton Limited ASX:BHP with B = K = $28
for half a share, priced at 1.79.

" 419
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

Fig. 11.3: Pricing data for an up-and-out put option with K = B = $28.

The attached code performs an implied volatility calculation for up-and-

out barrier put option (or Bear CBBC) prices with B < K, based on this
market data set.

Down-and-out barrier call option

Let us now consider a down-and-out barrier call option on the underlying

asset price St with exercise date T , strike price K, barrier level B, and payoff

S − K if min St > B,

 T

0⩽t⩽T

C = (ST − K )+ 1n o=
min St > B 0

if min St ⩽ B,
0⩽t⩽T 
0⩽t⩽T

with 0 ⩽ B ⩽ K. The down-and-out barrier call option is also called a

Callable Bull Contract, or a Bull CBBC with no residual value, or a turbo
warrant with no rebate, in which B denotes the call level.∗ When B ⩽ K,
we have
 

e −(T −t)r E∗ (ST − K )+ 1n o Ft  (11.10)

min St > B
0⩽t⩽T
     
T −t St T −t St
= St 1 Φ δ+ − e −(T −t)r K 1 t Φ δ−
mt0 >B K m0 >B K
∗
Download this code for the pricing of Bull CBBC (down-and-out barrier call op-
tions) with B ⩾ K (right-click to save as attachment).

420 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance


 2r/σ2
 2 
B B
−B 1 Φ δ+ T −t
mt0 >B St KSt
 1−2r/σ2   2 
St B
+ e −(T −t)r K 1 t Φ δ−T −t
m0 >B B KSt
= 1 t Bl(St , K, r, T − t, σ )
m0 >B
 2r/σ2
 2 
B B
−B 1 Φ δ T −t
+
mt0 >B St KSt
 1−2r/σ2   2 
St B
+ e −(T −t)r K 1 t Φ δ−T −t
m0 >B B KSt
= 1 t Bl(St , K, r, T − t, σ )
m0 >B
 2r/σ2  
B B K
−St 1 Bl , , r, T − t, σ ,
mt0 >B St St B

0 ⩽ t ⩽ T . When B ⩾ K, we find
 

e −(T −t)r
E ∗
(ST − K ) 1n +
o Ft  (11.11)
min St > B
0⩽t⩽T
     
T −t St T −t St
= St 1 t Φ δ+ − e −(T −t)r K 1 t Φ δ−
m0 >B B m0 >B B
 2r/σ2   
B B
−B 1 t Φ δ+T −t
m0 >B St St
 1−2r/σ2   
S B
+ e −(T −t)r K 1 t
t T −t
Φ δ− ,
m0 >B B St

St > B, 0 ⩽ t ⩽ T , see Exercise 11.1 below.

60
50
16 40
14
30
12
10 20
8
10
6
4 0
2 200
0 120
90 Time in days 160
80 160
70 200
Time in days 120
Underlying 60
50 60 70 80 90
50 Underlying

(a) Case B = 60 < K = 80. (b) Case K = 40 < B = 60.

Fig. 11.4: Graphs of the down-and-out call option price (11.10)-(11.11).

" 421
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

In the next Figure 11.5 we plot∗ the down-and-out barrier call option price
(11.11) as a function of volatility with B = 349.2 > K = 346.4, r = 0.03,
T = 99/365, and S0 = 360.
0.20

Bull CBBC Market Price

Bull CBBC Pricing Formula
S0 − Ke−rT
0.18

S0 − B
Bull CBBC Price
0.16
0.14
0.12
0.10

0.0 0.2 0.4 0.6 0.8 1.0

σ

Fig. 11.5: Down-and-out call option price as a function of σ.

We note that with such parameters, the down-and-out barrier call option
price (11.11) is upper bounded by the forward contract price S0 − K e −rT in
the limit as σ tends to zero, and that it decreases to S0 − B in the limit as σ
tends to infinity.

Down-and-out barrier put option

When K ⩾ B, the price

 
ST −t + n
 
e 1 mt >B E
−(T −t)r  ∗
K −x 1 o
0 S0 x min Sr /S0 > B
0⩽r⩽T −t x=St

of the down-and-out barrier put option with maturity T , strike price K and
barrier level B is given by
 
e −(T −t)r E∗ (K − ST )+ 1 T Ft
m0 >B
      
T −t St T −t St
= St 1 t Φ δ+ − Φ δ+
m0 >B K B
 1+2r/σ2    2     )
B T −t B T −t B
− Φ δ+ − Φ δ+
St KSt St
(      
T −t St T −t St
− e −(T −t)r K 1 t Φ δ− − Φ δ−
m0 >B K B

∗
Download this code for the pricing of down-and-out barrier call options (right-click
to save as attachment).

422 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

 1−2r/σ2    2     )
St T −t B T −t B
− Φ δ− − Φ δ−
B KSt St
      
T −t St T −t St
= St 1 t Φ −δ+ − Φ −δ+
m0 >B B K
 1+2r/σ2    2     )
B T −t B T −t B
− Φ δ+ − Φ δ+
St KSt St
(      
T −t St T −t St
− e −(T −t)r K 1 t Φ −δ− − Φ −δ−
m0 >B B K
 1−2r/σ2    2     )
St T −t B T −t B
− Φ δ− − Φ δ−
B KSt St
  
T −t St
= 1 t Blput (St , K, r, T − t, σ ) + St 1 t Φ −δ+ (11.12)
m0 >B m0 >B B
 2r/σ2    2    
B B B
−B 1 t Φ δ+ T −t
− Φ δ+ T −t
m0 >B St KSt St
  
T −t St
− e −(T −t)r K 1 t Φ −δ−
m0 >B B
 1−2r/σ2    2    
St B B
+ e −(T −t)r K 1 t Φ δ− T −t
− Φ δ−T −t
,
m0 >B B KSt St

while the corresponding price vanishes when K ⩽ B.

14
12
10
8
6
4
200
2
160 Time in days
0
50 60 120
70 80
Underlying 90

Fig. 11.6: Graph of the down-and-out put option price (11.12) with K = 80 > B = 65.

Note that although Figures 11.2b and 11.4a, resp. 11.2a and 11.4b, appear
to share some symmetry property, the functions themselves are not exactly
symmetric. Regarding Figures 11.1 and 11.6, the pricing function is actually
the same, but the conditions B < K and B > K play opposite roles.

" 423
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

11.3 Knock-In Barrier

Down-and-in barrier call option

When B ⩽ K, the price of the down-and-in barrier call option is given from
the down-and-out barrier call option price (11.10) and the down-in-out call
parity relation (11.2) as
 
e −(T −t)r E∗ (ST − K )+ 1 Ft (11.13)
mT
0 <B

= 1 Bl(St , K, r, T − t, σ )
mt0 ⩽B
 1+2r/σ2   2 
B B
+St 1 T −t
Φ δ+
mt0 >B St KSt
 1−2r/σ2   2 
St B
− e −(T −t)r K 1 Φ δ−T −t
.
mt0 >B B KSt

20

15

1
10
0.8
0.6 5
0.4
0
0.2 160180
0
180 200
90
80 Time in days
200
70 220
Underlying
220Time in days 50 40 30
60 80 70 60
90
50 Underlying

(a) Case K = 80 > B = 65. (b) Case K = 40 < B = 60.

Fig. 11.7: Graphs of the down-and-in call option price (11.13)-(11.14).

When B ⩾ K, the price of the down-and-in barrier call option is given from
the down-and-out barrier call option price (11.11) and the down-in-out call
parity relation (11.2) as
h i
e −(T −t)r E∗ (ST − K )+ 1 T Ft (11.14)
mt <B

= Bl(St , K, r, T − t, σ )
     
T −t St T −t St
−St 1 t Φ δ+ + e −(T −t)r K 1 t Φ δ−
m0 >B B m 0 >B B
 1+2r/σ2   
B B
+ 1 t St T −t
Φ δ+
m0 >B St St

424 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

 1−2r/σ2   
St B
− e −(T −t)r K 1 T −t
Φ δ− , 0 ⩽ t ⩽ T.
mt0 >B B St

Up-and-in barrier call option

When B ⩾ K, the price of the up-and-in barrier call option is given from
(11.5) and the up-in-out call parity relation (11.1) as
 
e −(T −t)r E∗ (ST − K )+ 1 T Ft (11.15)
M0 >B
  
T −t St
= 1 t Bl(St , K, r, T − t, σ ) + St 1 t Φ δ+
M0 ⩾B M0 <B B
 2r/σ2   2     !
B B B
+ B 1 t Φ δ+ T −t
− Φ δ+ T −t
M0 <B St KSt St
  
T −t St
− e −(T −t)r K 1 t Φ δ−
M0 <B B
 1−2r/σ2   2     !
−(T −t)r S t T −t B T −t B
−e K Φ δ− − Φ δ− .
B KSt St

25

20

15

10

5 180

200
0 Time in days
90
80 70 220
60 50
Underlying

Fig. 11.8: Graph of the up-and-in call option price (11.15) with B = 80 > K = 65.

When B ⩽ K, the price of the up-and-in barrier call option is given from the
Black-Scholes formula and the up-in-out call parity relation (11.1) as
h i
e −(T −t)r E∗ (ST − K )+ 1 T Ft = Bl(St , K, r, T − t, σ ).
M0 >B

" 425
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

Down-and-in barrier put option

When B ⩽ K, the price of the down-and-in barrier put option is given from
(11.12) and the down-in-out put parity relation (11.4) as
 
e −(T −t)r E∗ (K − ST )+ 1 T Ft (11.16)
mt <B
  
T −t St
= 1 t Blput (St , K, r, T − t, σ ) − St 1 t Φ −δ+
m0 ⩽B m0 >B B
 2r/σ2    2    
B B B
+ B 1 t Φ δ+ T −t
− Φ δ+ T −t
m0 >B St KSt St
  
T −t St
+e −(T −t)r
K1 t Φ −δ−
m0 >B B
 1−2r/σ2    2    
St B B
− e −(T −t)r K 1 t Φ δ−T −t
− Φ δ− T −t
,
m0 >B B KSt St

0 ⩽ t ⩽ T.

30
25
20
15
10
5
0
160
50
200 60
Time in days 70
80 Underlying
90

Fig. 11.9: Graph of the down-and-in put option price (11.16) with K = 80 > B = 65.

When B ⩾ K, the price of the down-and-in barrier put option is given from
the Black-Scholes put function and the down-in-out put parity relation (11.4)
as
 
e −(T −t)r E∗ (K − ST )+ 1 T Ft = Blput (St , K, r, T − t, σ ),
mt <B

0 ⩽ t ⩽ T.

Up-and-in barrier put option

When B ⩽ K, the price of the down-and-in barrier put option is given from
(11.8) and the up-in-out put parity relation (11.3) as

426 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

 
e −(T −t)r E∗ (K − ST )+ 1 Ft (11.17)
M0T >B

= Blput (St , K, r, T − t, σ )
 1+2r/σ2      !
B B T −t St
−St 1 t T −t
Φ −δ+ − Φ −δ+
M0 <B St St B
+K e −(T −t)r
 1−2r/σ2      !
St B T −t St
×1  T −t
Φ −δ− − Φ −δ− .
M0t <B B St B

0 ⩽ t ⩽ T.

1.2
10 1
8 0.8
6 0.6
180 180
4 0.4
2 200 0.2 200
Time in days Time in days
0 220 0 220
90 80 90 80
70 60 70 60
Underlying Underlying

(a) K = 80 > B = 70. (b) Case K = 70 < B = 80.

Fig. 11.10: Graphs of the up-and-in put option price (11.17)-(11.18).

By (11.9) and the up-in-out put parity relation (11.3), the price of the up-
and-in barrier put option is given when B ⩾ K by
h i
e −(T −t)r E∗ (K − ST )+ 1 T Ft (11.18)
M0 >B

= 1 Blput (St , K, r, T − t, σ )
M0t ⩾B
 1+2r/σ2
  2 
B B
−St 1 T −t
Φ −δ+
M0t <B St KSt
 1−2r/σ2   2 
St B
+ K 1 e −(T −t)r Φ −δ−T −t
.
M0t <B B KSt

11.4 PDE Method

The up-and-out barrier call option price has been evaluated by probabilistic
arguments in the previous sections. In this section we complement this ap-
proach with the derivation of a Partial Differential Equation (PDE) for this
option price function.

" 427
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

The up-and-out barrier call option price can be written as

h i
e −(T −t)r E∗ (ST − K )+ 1 T Ft
M0 <B
h i
= e −(T −t)r E∗ (ST − K )+ 1n o 1n o Ft
Max Sr < B Max Sr < B
0⩽r⩽t t⩽r⩽T
 

= e −(T −t)r 1n o E∗ (ST − K )+ 1n o Ft 

Max Sr < B Max Sr < B
0⩽r⩽t t⩽r⩽T
= 1 g (t, St ),
M0t <B

where the function g (t, x) of t and St is given by

 

g (t, x) = e −(T −t)r

E ∗
(ST − K ) 1n
+ o St = x . (11.19)
Max Sr < B
t⩽r⩽T

Next, by the same argument as in the proof of Proposition 6.1 we derive

the Black-Scholes partial differential equation (PDE) satisfied by g (t, x), and
written for the value of a self-financing portfolio.
Proposition 11.3. Let (ηt , ξt )t∈R+ be a portfolio strategy such that
(i) (ηt , ξt )t∈R+ is self-financing,
(ii) the portfolio value Vt := ηt At + ξt St , t ⩾ 0, is given as in (11.19) by

Vt = 1 g (t, St ), t ⩾ 0.
M0t <B

Then, the function g (t, x) pricing the up-and-out barrier call option satisfies
the Black-Scholes PDE
∂g ∂g 1 ∂2g
rg (t, x) = (t, x) + rx (t, x) + x2 σ 2 2 (t, x), (11.20)
∂t ∂x 2 ∂x
t > 0, 0 < x < B, and ξt is given by
∂g
ξt = (t, St ), 0 ⩽ t ⩽ T, (11.21)
∂x
provided that M0t < B.
Proof. By (11.19) the price at time t of the up-and-out barrier call option
discounted to time 0 is given by

e −rt 1 g (t, St )
M0t <B

428 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

 

= e −rT
1M t <B E ∗
(ST − K ) 1n
+ o Ft 
0 Max Sr < B
t⩽r⩽T
 

= e −rT E∗ (ST − K )+ 1 1n o Ft 
M0t <B Max Sr < B
t⩽r⩽T
 

= e −rT E∗ (ST − K )+ 1n o St  ,
Max Sr < B
0⩽r⩽T

which is a martingale indexed by t ⩾ 0. Next, applying the Itô formula to

t 7−→ e −rt g (t, St ) “on {M0t ⩽ B, 0 ⩽ t ⩽ T }”, we have

d( e −rt g (t, St )) = − r e −rt g (t, St )dt + e −rt dg (t, St )

∂g
= −r e −rt g (t, St )dt + e −rt (t, St )dt
∂t
−rt ∂g 1 −rt 2 2 ∂ 2 g
+ r e St (t, St )dt + e σ St 2 (t, St )dt
∂x 2 ∂x
∂g
+ e −rt σSt (t, St )dWt . (11.22)
∂x
In order to derive (11.21) we note that, as in the proof of Proposition 6.1,
the self-financing condition (5.8) implies

d( e −rt Vt ) = −r e −rt Vt dt + e −rt dVt

= −r e −rt Vt dt + ηt e −rt dAt + ξt e −rt dSt
= −r (ηt At + ξt St ) e −rt dt + rηt At e −rt dt + rξt St e −rt dt + σξt St e −rt dWt
= σξt St e −rt dWt , t ⩾ 0, (11.23)

and (11.21) follows by identification of (11.22) with (11.23) which shows that
the sum of components in factor of dt have to vanish, hence

∂g ∂g σ2 ∂ 2 g
−rg (t, St ) + (t, St ) + rSt (t, St ) + St2 2 (t, St ) = 0.
∂t ∂x 2 ∂x
□
In the next proposition we add a boundary condition to the Black-Scholes
PDE (11.20) in order to hedge the up-and-out barrier call option with ma-
turity T , strike price K, barrier (or call level) B, and payoff

S − K if Max St ⩽ B,

 T

0⩽t⩽T

C = (ST − K )+ 1n o=
Max St < B 0

if Max St > B,
0⩽t⩽T 
0⩽t⩽T

" 429
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

with B ⩾ K.
Proposition 11.4. The value Vt = 1M t <B g (t, St ) of the self-financing
0
portfolio hedging the up-and-out barrier call option satisfies the Black-Scholes
PDE


∂g ∂g 1 ∂2g
(t, x) + rx (t, x) + x2 σ 2 2 (t, x), (11.24a)

rg (t, x) =


2



 ∂t ∂x ∂x




 g (t, x) = 0, x ⩾ B, t ∈ [0, T ], (11.24b)





g (T , x) = (x − K )+ 1{x<B} , (11.24c)



on the time-space domain [0, T ] × [0, B ] with terminal condition

g (T , x) = (x − K )+ 1{x<B}

and additional boundary condition

g (t, x) = 0, x ⩾ B. (11.25)

Condition (11.25) holds since the price of the claim at time t is 0 whenever
St = B. When K ⩽ B, the closed-form solution of the PDE (11.24a) under
the boundary conditions (11.24b)-(11.24c) is given from (11.5) in Proposi-
tion 11.2 as

T −t x T −t x
      
g (t, x) = x Φ δ+ − Φ δ+ (11.26)
K B
 x −1−2r/σ2    2    
T −t B T −t B
−x Φ δ+ − Φ δ+
B Kx x
   x    x 
−(T −t)r T −t T −t
−K e Φ δ− − Φ δ−
K B
 x 1−2r/σ2    2    
−(T −t)r T −t B T −t B
+K e Φ δ− − Φ δ− ,
B Kx x

0 < x ⩽ B, 0 ⩽ t ⩽ T ,

see Figure 11.1. We note that the expression (11.26) can be rewritten using
the standard Black-Scholes formula
     
S S
Bl(S, K, r, T , σ ) = SΦ δ+
T
− K e −rT Φ δ− T
K K

430 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

for the price of the European call option, as

T −t x T −t x
     
g (t, x) = Bl(x, K, r, T − t, σ ) − xΦ δ+ + e −(T −t)r KΦ δ−
B B
 2r/σ2    2    
B T −t B T −t B
−B Φ δ+ − Φ δ+
x Kx x
 x 1−2r/σ2 B2
      
−(T −t)r T −t T −t B
+e K Φ δ− − Φ δ− ,
B Kx x

0 < x ⩽ B, 0 ⩽ t ⩽ T .
Table 11.2 summarizes the boundary conditions satisfied for barrier option
pricing in the Black-Scholes PDE.

Boundary conditions
Option type CBBC Behavior
Maturity T Barrier B
down-and-out B ⩽ K (x − K ) + 0
Bull
(knock-out) B⩾K (x − K )+ 1{x>B} 0
down-and-in B⩽K 0 Bl(B, K, r, T − t, σ )
(knock-in) B⩾K (x − K )+ 1{x<B} Bl(B, K, r, T − t, σ )
Barrier call
up-and-out B⩽K 0 0
(knock-out) B⩾K (x − K )+ 1{x<B} 0
up-and-in B⩽K (x − K ) + 0
(knock-in) B⩾K (x − K )+ 1{x>B} Bl(B, K, r, T − t, σ )
down-and-out B ⩽ K (K − x)+ 1{x>B} 0
(knock-out) B⩾K 0 0
down-and-in B⩽K (K − x)+ 1{x<B} Blp (B, K, r, T − t, σ )
(knock-in) B⩾K (K − x)+ 0
Barrier put
up-and-out B⩽K (K − x)+ 1{x<B} 0
Bear
(knock-out) B⩾K (K − x) + 0
up-and-in B⩽K (K − x)+ 1{x>B} Blp (B, K, r, T − t, σ )
(knock-in) B⩾K 0 Blp (B, K, r, T − t, σ )

Table 11.2: Boundary conditions for barrier option prices.

11.5 Hedging Barrier Options

Figure 11.11 represents the value of Delta obtained from (11.21) for the up-
and-out barrier call option in Exercise 11.1-(a).

" 431
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

220
200 90
180 85
80
160 75
t 140 70
65
120 60 St
55
100 50

Fig. 11.11: Delta of the up-and-out barrier call with B = 80 > K = 55.∗

Down-and-out barrier call option

Similarly, the price g (t, St ) at time t of the down-and-out barrier call option
satisfies the Black-Scholes PDE

 rg (t, x) = ∂g (t, x) + rx ∂g (t, x) + 1 x2 σ 2 ∂ g (t, x),


 2

2 ∂x2




 ∂t ∂x


 g (t, B ) = 0, t ∈ [0, T ],


 g (T , x) = (x − K ) + 1

{x>B} ,


on the time-space domain [0, T ] × [0, B ] with terminal condition g (T , x) =

(x − K )+ 1{x>B} and the additional boundary condition

g (t, x) = 0, x ⩽ B,

since the price of the claim at time t is 0 whenever St ⩽ B, see (11.10) and
Figure 11.4a when B ⩽ K, and (11.11) and Figure 11.4b when B ⩾ K.

Exercises

Exercise 11.1 Barrier options.

a) Compute the delta hedging strategies of the up-and-out barrier call and
put options on the underlying asset price St with exercise date T , strike
price K and barrier level B, with B ⩾ K.
∗
The animation works in Acrobat Reader on the entire pdf file.

432 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

b) Compute the joint probability density function

dP(YT ⩽ a and WT ⩽ b)
φYT ,WT (a, b) = , a, b ∈ R,
dadb
of standard Brownian motion WT and its minimum

YT = min Wt .
t∈[0,T ]

c) Compute the joint probability density function

b
dP(Y T ⩽ a and W
fT ⩽ b)
, a, b ∈ R,
b
φ e T (a, b) =
Y T ,W dadb

of drifted Brownian motion W

fT = WT + µT and its minimum
b
Y T = min Wft = min (Wt + µt).
t∈[0,T ] t∈[0,T ]

d) Compute the price at time t ∈ [0, T ] of the down-and-out barrier call

option on the underlying asset price St with exercise date T , strike price
K, barrier level B, and payoff

 ST − K if 0⩽ min St > B,


 t⩽T
C = (ST − K ) 1+ n o =
min St > B 0

 if min St ⩽ B,
0⩽t⩽T 0⩽t⩽T

in cases 0 < B < K and B ⩾ K.

Exercise 11.2 Pricing Category ’R’ CBBC rebates. Given τ > 0, consider
an asset price (St )t∈[τ ,∞) , given by
2 t/2
Sτ +t = Sτ e rt+σWt −σ , t ⩾ 0,

where (Wt )t∈R+ is a standard Brownian motion, with r ⩾ 0 and σ > 0. In

what follows, ∆τ is the deterministic length of the Mandatory Call Event
(MCE) valuation period which commences from the time upon which a MCE
occurs up to the end of the following trading session.
h + i
a) Compute the expected rebate (or residual) E min Sτ +s − K Fτ
s∈[0,∆τ ]
of a Category ’R’ Bull CBBC Contract (down-and-out barrier call option)
having expired at a given time τ < T , knowing that Sτ = B > K > 0,
with r > 0.

" 433
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

h + i
b) Compute the expected rebate E min Sτ +s − K Fτ of a Cat-
s∈[0,∆τ ]
egory ’R’ Bull CBBC Contract having expired at a given time τ < T ,
knowing that Sτ = B > K > 0, with r = 0.
c) Find the expression of the probability density function of the first hitting
time
τB = inf{t ⩾ 0 : St = B}
of the level B > 0 by the process (St )t∈R+ .
d) Price the CBBC rebate
h  + i
e −r∆τ E e −rτ 1[0,T ] (τ ) min St − K
t∈[τ ,τ +∆τ ]
h h + ii
= e −r∆τ E e −rτ 1[0,T ] (τ )E min St − K Fτ .
t∈[τ ,τ +∆τ ]

Exercise 11.3 Barrier forward contracts. Compute the price at time t of

the following barrier forward contracts on the underlying asset price St with
exercise date T , strike price K, barrier level B, and the following payoffs. In
addition, compute the corresponding hedging strategies.
a) Up-and-in barrier long forward contract. Take

 ST − K if 0Max

 St > B,
 ⩽t⩽T
C = (ST − K ) 1n o=
Max St > B 0

 if Max St ⩽ B.
0⩽t⩽T 0⩽t⩽T

b) Up-and-out barrier long forward contract. Take

S − K if Max St < B,

 T

0⩽t⩽T

C = (ST − K ) 1n o=
Max St < B 0

if Max St ⩾ B.
0⩽t⩽T 
0⩽t⩽T

c) Down-and-in barrier long forward contract. Take

 ST − K if 0⩽
min St < B,


 t⩽T
C = (ST − K ) 1 n o =
min St < B 0

 if min St ⩾ B.
0⩽t⩽T 0⩽t⩽T

d) Down-and-out barrier long forward contract. Take

434 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

 ST − K if 0⩽
min St > B,


 t⩽T
C = (ST − K ) 1n o=
min St > B 0

 if min St ⩽ B.
0⩽t⩽T 0⩽t⩽T

e) Up-and-in barrier short forward contract. Take

K − ST if Max St > B,


0⩽t⩽T


C = (K − ST ) 1n o=
Max St > B 0

if Max St ⩽ B.
0⩽t⩽T 
0⩽t⩽T

f) Up-and-out barrier short forward contract. Take

 K − ST if 0Max

 St < B,
 ⩽t⩽T
C = (K − ST ) 1 n o =
Max St < B 0

 if Max St ⩾ B.
0⩽t⩽T 0⩽t⩽T

g) Down-and-in barrier short forward contract. Take

K − ST if min St < B,


0⩽t⩽T


C = (K − ST ) 1n o=
min St < B 0

 if min St ⩾ B.
0⩽t⩽T 0⩽t⩽T

h) Down-and-out barrier short forward contract. Take

 K − ST if 0⩽min St > B,


 t⩽T
C = (K − ST ) 1 n o =
min St > B 0

 if min St ⩽ B.
0⩽t⩽T 0⩽t⩽T

Exercise 11.4 Compute the Vega of the down-and-out and down-and-in

barrier call option prices, i.e. compute the sensitivity of down-and-out and
down-and-in barrier option prices with respect to the volatility parameter σ.

Exercise 11.5 Stability warrants. Price the up-and-out binary barrier option
with payoff

C := 1{ST >K} 1 = 1
M0T <B ST >K and M0T ⩽B

at time t = 0, with K ⩽ B.

" 435
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html
 N. Privault

Exercise 11.6 Check that the function g (t, x) in (11.26) satisfies the bound-
ary conditions
g (t, B ) = 0, t ∈ [0, T ],








 g (T , x) = 0, x ⩽ K < B,




g (T , x) = x − K, K ⩽ x < B,










g (T , x) = 0, x > B.


Exercise 11.7 European knock-in/knock-out barrier options. Price the fol-

lowing vanilla options by computing their conditional discounted expected
payoffs:
a) European knock-out barrier call option with payoff (ST − K )+ 1{ST ⩽B} ,
b) European knock-in barrier put option with payoff (K − ST )+ 1{ST ⩽B} ,
c) European knock-in barrier call option with payoff (ST − K )+ 1{ST ⩾B} ,
d) European knock-out barrier put option with payoff (K − ST )+ 1{ST ⩾B} ,

436 "
This version: January 10, 2024
https://personal.ntu.edu.sg/nprivault/indext.html