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

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

Calculus,

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

t 0 ,e define (1)

the running .a-i.u. as

8t <

.a- ;s

0st

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

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

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

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

the distri*ution of the running .a-i.u. is rather co.plicated and often cannot *e ,ritten out in a closed for.
'ut it turns out that for a general stochastic process ;t

is a 'ro,nian .otion ,e can e-plicitl+ calculate the distri*ution of the running .a-i.u. and hitting ti.e
'ro,nian .otion )n the case ,hen stochastic process ;t 0heore. 1 (Reflection Arinciple ) Let a > 0 0hen A(0 a ?

t) < 2A('t

> a)
Re.ar4 2 'efore the start of the proof let us re,rite the a*o/e e3uation as 2 r - @ de A(0a ? t) < 2 (2t) 2Bt
a

(C)

0o find the pro*a*ilit+ densit+ of 0a ,e

/aria*les - <
and

change a

ta s

0hen d<

ta

rt A(0a ?

2s

3@2 (#)

t) <
0
2

2Bs

e 3

a @2s

ds,

2Bs

and thus the densit+ of 0a is Aroof 5ssu.e that 't

a @2s

hits le/el propert+ a at so.e ti.e sthat ? t ':ro. the independence of incre.ents it ti.e follo,s '0 is a t independent of ,hat happened *efore 0 8oreo/er, the incre.ent 't '0a is nor.all+ distri*uted Since a
nor.al distri*ution is s+..etric and pro*a*ilit+ of ' t *eing

e3ual to a is 6ero (D)

,e o*tain

A(0a ?

t, 't >

9e .ultipl+ *+ 2 and notice that e/ent {'t >

a) <

A(0a ?

t)

t},

a} is a su*set of the e/ent {0a ? (%)

E

thus A(0a ?

t) < 2A(0a ? t, 't > a) < 2A('t > a)

'0a is independent of F0a (1infor" .ation2 a/aila*le at ti.e 0 a) needs to *e pro/ed using the strong 8ar4o/ propert+ for 'ro,nian .otion 9e refer to [2] for the proof
Re.ar4 3 0rul+ spea4ing, the fact that 't (ne can go further and generali6e the result of 0heore. 1 Let u ? / a, then using the reflection principle ,e can easil+ sho, that

t, u ? 't ? /) < A(2a / ? 't ? 2a u) Since e/ents {0a ? t} and {8t > a} are e3ui/alent ,e o*tain A(8t > a, u ? 't ? /) < A(2a / ? 't ? 2a u)
A(0a ? Fo, let the inter/al (u, /) shrin4 to -, so that A(8t >
(2t)

(!)

($)

a, 't < -) < A('t < 2a (10)

-) <
2Bt

(2a-) @

Eifferentiating ,ith respect to a ,e get the =oint densit+ 2 2(2a (2a-) e A(8t < a, 't < -) 3 -) <

@(2t)

(11)

2Bt

7noc4")n@(ut (ption on 'ro,nian .otion Let us consider the option ,hich is 4noc4ed"out if *efore the e-piration ti.e t asset price crosses *arrier 8 0he pa+off at e-piration is a call ,ith stri4e 7 Let us assu.e for si.plicit+ that the interest rate is e3ual to 6ero so that the /alue of the option is e3ual to G 18t ?8 ('t 7)H (12) )n order to calculate the a*o/e e-pectation ,e use our 4no,ledge of the =oint densit+ of 8t and 't gi/en *+ (11): 2 r r 1 dad(- 2(2a e(2a a?8 -) @(2t) 18t ?8 ('t 7)H < 7)H -) 2Bt3
88

<

rr

-)
7 8 -

(- 7)

2(2a
2Bt
3

(2a-) @ (2t)
dad2

8
2

(-28 ) @2t

- @2t

2Bt
<

r
7

7)

(- 7)

d-
7

(-

2Bt

d-

(13)

0he a*o/e difference could *e easil+ e-pressed in ter.s of the cu.ulati/e nor.al distri*ution )ndeed, the first ter. is a difference of the follo,ing t,o integrals
8

2t

-2 @

8@

t d- <
2Bt B

- @2

e < 2 d-

t e

7 @2t

t
r
7@

e
2

8 @2t

r 7 8

@ 2t
-2

2B

r 7
7

2Bt

t 8@ 2 t e- @2
r 2B

<

d- <

7@

8 7 , t F t

(1C)

t
,here F (-) <

Let us re.ar4 that @the sa.e .ethod applies for the case of general pa+off and 4noc4"out the pa+off is gi/en *+ of function f (-) and 4noc4"out condition condition is)fgi/en *+ 8tat e-piration 5 then the /alue the option is 2 r r 2(2a (2a-) @(2t) 1 e dad(1#) a 5 -) f (-) 3 2Bt

6 e @2

2Bd6 is the cu.ulati/e nor.al distri*ution

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

Let us start ,ith the proof that for an+ positi/e constant J stochastic process Kt <
2

eJ't

J2t@2

is a .artingale )ndeed, for s ? t

J'

G e

J t@2

J('

|Fs < G e
J'

'

)HJ'

s t

J t@2

|Fs
'

<e

s s

J t@2
2 2

J('

G e e

|Fs

(1D) (1%)

J'

J t@2 J (ts)@2

<e G3uation (1D) follo,s fro. the fact that 's

is .easura*le in J"alge*ra Fs, or in other ,ords, ,ith infor.ation up to ti.e s at +our disposal +ou 4no, 's G3uation
(1%) follo,s fro. the independence of incre.ents propert+ and the fact that for a nor.all+ distri*uted rando. /aria*le ; 2 < 2F (a, J2) Geu; <
1

euaH 2 u J (1!) Let us use the fact that Kt is a .artingale to find the .o.ent generating function of the first passage ti.e 0a Let us appl+ the .artingale propert+ at .o.ent 0a : G (K0a |F0) < K0, (1$)
or e3ui/alentl+ 'ut '0a <

GeJ'0a
2

J 0a @2

<1
J 0
2

(20) a
@2 Ja

a *+ the definition of the first passage ti.e 0hus

JaJ 0

Changing /aria*le J2 <

Ge

@2

2u

< 1 Ge
u0

<e

(21)

Ge

<e

a 2u

(22)

0hus ,e o*tained the .o.ent generating function of the first passage ti.e 0 a

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