Mathematical Social Sciences 45 (2003) 75–82

www.elsevier.com / locate / econbase

A generalization of the Geske formula for compound options

Agliardi Elettra a , Agliardi Rossella b , *
a
University of Bologna, Bologna, Italy
b
Department of Mathematics, University of Ferrara, Via Machiavelli 35, 44100 Ferrara, Italy
Received 1 March 2002; received in revised form 1 September 2002; accepted 1 September 2002

Abstract

A generalization of the Geske formula for compound options is derived in the case of
time-dependent volatility and interest rate. A comparison with the Geman–El Karoui–Rochet
formula is also provided. Such a generalization seems to be more appropriate for the evaluation of
compound real (growth) options.
 2002 Elsevier Science B.V. All rights reserved.

Keywords: Compound options; Pricing; Time-dependence; Bivariate normal distribution

JEL classification: G12; G13; G30; C69

1. Introduction

Compound options are merely options of options. Since Geske (1979) an analytical
formula for the price of compound options was worked out within the Black-Scholes
framework. Basically, the procedure consists of the following two steps: at first the
underlying option is priced according to the Black-Scholes method; then, the compound
option is priced as an option on the security whose value has already been found in the
first step.
Compound options have been extensively used in corporate finance, where corporate
investment opportunities may be viewed as options. In the corporate finance setting the
underlying asset is the total value of the firm’s assets, V; the various corporate securities,
such as equity, warrants, and convertible bonds, can be valued as claims contingent on V.
Thus, in this paper we adopt the notation of such a framework and consider compound

*Corresponding author. Fax: 139-53-224-7292.

E-mail address: agl@dns.unife.it (A. Rossella).

0165-4896 / 02 / $ – see front matter  2002 Elsevier Science B.V. All rights reserved.
doi:10.1016/S0165-4896(02)00081-1
76 A. Elettra, A. Rossella / Mathematical Social Sciences 45 (2003) 75–82

options, where the underlying option is a stock issued by a firm, which is depicted as an
option on the value of the firm V.
In Geske (1979) the analytical formulae are obtained when volatility is constant.
However, because of the second order nature of compound options, their sensitivity to
the underlying parameters is magnified and then these formulae can be hardly used in
practice. This notwithstanding, Geske’s framework has provided insights for the analysis
of real compound or growth options. Many real investments—for example, in R&D, in a
strategic acquisition, or in an information-technology network—are undertaken not only
for their expected directly measurable cash flows, but also for the future growth
opportunities they may unlock—for example, in terms of new technological break-
throughs or access to new markets: therefore, such investments may be seen as
compound options, which have to be evaluated not as independent options, but rather as
links in a chain of interrelated projects, the earlier of which may be prerequisites for
those to follow. The valuation of compound options has potential implications for the
valuation of several compound real (growth) opportunities where earlier investments are
prerequisites for others to follow. For example, building on Geske (1979), Carr (1988)
analyzes sequential (compound) options, which involve options to acquire subsequent
options to exchange the underlying asset for another risky asset. (See also Brealey and
Myers, 1991; Geske and Johnson, 1984; Trigeorgis, 1996).
In the above-mentioned applications the assumptions of constant volatility and interest
rate seem to be inadequate. In this paper we find a generalization of the formula for
compound options in the case of time-dependent volatility and interest rate. Such a
generalization is more appropriate, in view of the sequential nature of compound
options.

2. A formula for compound call options

Let V denote the current value of the firm, S the current market value of the firm’s
stock, B the face value of the firm’s debt which is a pure discount bond with a maturity
of T years. We assume that the value of the firm follows a stochastic differential equation
of the form:
dV/V 5 m (t) dt 1 s (t) dWt ,
where Wt is a standard Wiener process, m (t) is the instantaneous expected rate of return
on the firm at time t and s 2 (t) is the instantaneous variance of the return on the firm at
time t. Note that in contrast with Geske (1979) m and s 2 are assumed to change with
time.
As in Geske (1979), we suppose that the firm’s stock can be viewed as an option on
the firm’s value. Thus, in view of Ito’s Lemma, the stock’s equilibrium path follows the
usual partial differential equation:
≠S ≠S 1 ≠ 2S
] 5 r(t)S 2 r(t)V ] 2 ] s 2 (t)V 2 ]]2 , (1)
≠t ≠V 2 ≠V
where r(t) denotes the risk-free rate of interest.
 A. Elettra, A. Rossella / Mathematical Social Sciences 45 (2003) 75–82 77

If at time T, the expiration date of the bonds, the value of the firm is greater than the
face value of the debt, B, then, after liquidating the debt, the remaining value will be
payed to the stockholders; if, at time T, the value of the firm is less than or equal to B,
then the stock is unworthy. Thus the boundary condition for Eq. (1) is
ST 5 max(VT 2 B, 0) (2)

As is well-known (see Merton, 1973), the solution to (1) subject to the boundary
condition (2) is
T

1E 2
S(V, t) 5VN(k 2 (t)) 2 exp 2 r(t ) dt BN(k 1 (t)),
t
(3)

where
T T 1/2

1 ES V
k 1 (t) 5 ln ] 1
B
t
1
2
D 2Y1E s (t) dt2
r(t ) 2 ] s 2 (t ) dt
t
2

(4)
T T 1/2

1 ES V
k 2 (t) 5 ln ] 1
B
t
1
2
D 2Y1E s (t) dt2
r(t ) 1 ] s 2 (t ) dt
t
2

and N(.) is the cumulative normal distribution function.

Now let us derive a formula for the value c of a European call option on the stock S,
that is c 5 f(S, t), with exercise price X and expiration date t*, t* # T. Since S is viewed
as an option on the value of the firm, this call option can be regarded as an option on an
option, or a compound option, that is, its value c depends on V and t. The usual riskless
hedging argument yields the following partial differential equation:
≠c ≠c 1 ≠ 2c
] 5 r(t)c 2 r(t)V ] 2 ] s 2 (t)V 2 ]]2 (5)
≠t ≠V 2 ≠V
The boundary condition is
c t * 5 max(St * 2 X, 0) (6)
Let V * denote the value of V such that St * 2 X 5 0, where St is given by (3). For values
of the firm greater than V * the call option on the stock will be exercised, while for
values less than V * it will remain unexercised. Note that existence and uniqueness of V *
is guaranteed because of expressions (3) and (4).
Let us define:
t* t* 1/2

1 V
h 1 (t) 5 ln ] 1
V*
ES 1
D 2Y1E s (t) dt2
r(t ) 2 ] s 2 (t ) dt
2
2

t t
t* t* 1/2 (7)

1 V
h 2 (t) 5 ln ] 1
V*
ES 1
D 2Y1E s (t) dt2
r(t ) 1 ] s 2 (t ) dt
2
2

t t
78 A. Elettra, A. Rossella / Mathematical Social Sciences 45 (2003) 75–82

In order to solve (5), (6), we make the following substitutions:

t*

1E 2
˜ z),
c(V, t) 5 exp 2 r(t ) dt c(u,
t

where
t*
V
u 5 2 ln ] 2
V*
E Sr(t) 2 ]12 s (t)D dt 2

and
t*
1
z5]
2
E s (t) dt. 2

Thus, expression (5) is transformed into the heat equation ≠ z c˜ 5 ≠ u2 c˜ and c(V, t) can be
written as follows:
t* 1`

1 E 2Es
exp 2 r(t ) dt
t 2`
Œ]
4p zd 21 exp(2(u 2 j )2 /(4z))c(
˜ j , 0) dj (8)

Plugging (3) into (8), we obtain:

t* 0

1 E 2 5E
exp 2 r(t ) dt
t 2`
] ]
(Œ4p z)21 exp(2(h 1 1 j /Œ2z)2 / 2)VN(k 2 (t*)) dj 2

0 T

B E ] ]
(Œ4p z)21 exp(2(h 1 1 j /Œ2z)2 / 2) exp 2 r(t ) dt N(k 1 (t*)) dj 2
1E 2
2` t*
0

X E (Œ4]pz) 21 ]
exp(2(h 1 1 j /Œ2z)2 / 2) dj .
6 (9)
2`

The third term in (9) can be easily written in the form:

t*

1E 2
2 X exp 2 r(t ) dt N(h 1 (t)).
t

In order to write the other terms in a form that resembles the one in Geske (1979), let
us set:
t* T 1/2

r (t) 5
1E t
2
s (t ) dt YE s (t) dt2
t
2
(10)
 A. Elettra, A. Rossella / Mathematical Social Sciences 45 (2003) 75–82 79

] ]
Setting x 5 h 2 (t) 1 j /Œ2z in the integral of the first term in (9) and x 5 h 1 (t) 1 j /Œ2z
in the integral of the second term in (9), we write the first term in the form:
t* h 2 (t )

1E 2 E
exp 2 r(t ) dt V
t 2`
] ]]
(Œ2p )21 exp(2x 2 / 2)N((k 2 (t) 2 r x) /œ1 2 r 2 ) dx,

and the second term in the form:

T h 1 (t )

1E 2 E
exp 2 r(t ) dt V
t 2`
] ]]
(Œ2p )21 exp(2x 2 / 2)N((k 1 (t) 2 r x) /œ1 2 r 2 ) dx.

Now we remind that

h

E (Œ]2p) 21 ]]
exp(2x 2 / 2)N((k 2 r x) /œ1 2 r 2 ) dx
2`

can be written in the form:

h k

E E (2pœ]]
12r ) 2 21
exp(2(x 2 1 y 2 2 2r xy) /(2 2 2r 2 )) dx dy,
2` 2`

which is the bivariate cumulative normal distribution N(h, k; r ) with r as the correlation
coefficient.
Finally we obtain:
T

1E 2
c(V, t) 5VN(h 2 (t), k 2 (t); r (t)) 2 B exp 2 r(t ) dt N(h 1 (t), k 1 (t); r (t))
t
t*

1E 2
2 X exp 2 r(t ) dt N(h 1 (t)),
t
(11)

where the h i s are given by (7), the k i s by (4) and r by (10).

Remark 1. The formula (11) captures the generalized Black-Scholes formula with
interest rate and volatility depending on time. Indeed, if B 5 0, that is, the firm is
unlevered, then the call option is written on an equity whose value is exactly the value of
the firm and, therefore, (11) reduces to:
t*

1E 2
c(V, t) 5VN(h 2 (t)) 2 X exp 2 r(t ) dt N(h 1 (t)),
t

where
80 A. Elettra, A. Rossella / Mathematical Social Sciences 45 (2003) 75–82

t* t* 1/2

1 ES V
h 1 (t) 5 ln ] 1
X
t
1
2
D 2Y1E s (t) dt2
r(t ) 2 ] s 2 (t ) dt
t
2

t* t* 1/2

1 ES V
h 2 (t) 5 ln ] 1
X
t
1
2
D 2Y1E s (t) dt2
r(t ) 1 ] s 2 (t ) dt
t
2

3. A comparison with the Geske formula

The formula obtained in Geske (1979) is a special case of (11), where r and s are
assumed to be constant. To parallel the analysis, we show that Geske’s remarks about
the response of the compound option price to changes in the values of the parameters are
essentially maintained in this framework. Before we pursue the computation of the
derivatives of c, we observe that ≠c / ≠h 1 5 0, ≠c / ≠k 1 5 0 and ≠c / ≠r 5 0. Thus we
obtain:

≠c
(i) ] 5 N(h 1 , k 2 , r ) . 0
≠V

that is, an increase in the value of the firm rises the value of the option;
T
≠c
1E 2
(ii) ] 5 2 exp 2 r(t ) dt N(h 1 , k 1 , r ) , 0
≠B
t

since the value of the firm is distributed between debt and equity, an increase of the face
value of the debt causes the call value to fall;
t*
≠c
1E 2
(iii) ] 5 2 exp 2 r(t ) dt N(h 1 ) , 0
≠X
t

that is, it is confirmed that the call value decreases as the exercise price increases.

T ]]]
T
≠c
1 E 25 S
(iv) ] 5 B exp 2 r(t ) dt
≠T
t
h1 2 rk1
N ]]] D 2
]]2 N9(k 1 )s (T ) 2
œ1 2 r 1 œE t
2
s 2 (t ) dt

1 N(h 1 , k 1 , r )r(T ) 6 .0

indeed, if the maturity date of the debt is postponed, the present value of the debt is
reduced, thus increasing the value of the call. The expression of the rate of this increase
points out the role of the interest rate and the volatility at the maturity date;
 A. Elettra, A. Rossella / Mathematical Social Sciences 45 (2003) 75–82 81

t
≠c
1E
(vi) ] 5 X r(t*)exp 2 r(t ) dt N(h 1 )
≠t*
t
2
]]]
t*

S
h2 2 rk2
1 N ]]]
2
]]2 N(h 2 )s (t*)
œ1 2 r
D Y12œE s (t) dt2
t
2

the value of the call is an increasing function of its expiration date, as is well-known.
The role of the interest rate and the volatility at the expiration date is emphasized here.

4. A comparison with the formula of Geman–El Karoui–Rochet

´
In Geman et al. (1995), using the change of numeraire formula, an explicit expression
for the value of compound options is written down in the case of general interest rate
and constant volatility s. For reader’s convenience we recall here the formula in Geman
et al. (1995), using our notation.
] ]
c(V, 0) 5VN(h 1 1 sŒt*, k 1 1 sŒT, r ) 2 BbT (0)N(h 1 , k 1 , r ) 2 Xbt * (0)N(h 1 ) (12)

where

h 1 5 ]]
1
sŒt*
] lnS V
]]] 2 ]] ,
V *bt* (0)
s 2 t*
2 D 1
k 1 5 ]]
sŒT
] ln
V
Ss 2T
]] 2 ]] ,
BbT (0) 2 D
]
t*
r 5 ]
œ T
and bs (t) denotes the price of the bond with maturity date s at time t.
If bs (t) 5 exp(2ets r(t ) dt ) and the volatility is constant, then (11) and (12) coincide.
One can guess that extending the formula of Geman–El Karoui–Rochet to the case of
a variable s, as in our model, the following expression would arise:

c(V, t) 5VN(h 2 (t), k 2 (t); r (t)) 2 BbT (t)N(h 1 (t), k 1 (t); r (t)) 2 Xbt* (t)N(h 1 (t)),

where
t* t* 1/2

1 V
h 1 (t) 5 ln ]]] 2 ]
1
V *bt * (t) 2
E s (t) dt2Y1E s (t) dt2
2 2
,
t t

t* t* 1/2

1 V
h 2 (t) 5 ln ]]] 1 ]
1
V *bt * (t) 2
E s (t) dt2Y1E s (t) dt2
2 2
,
t t

T T 1/2

1 V
k 1 (t) 5 ln ]] 2 ]
1
BbT (t) 2
E s (t) dt2Y1E s (t) dt2
2 2
,
t t
82 A. Elettra, A. Rossella / Mathematical Social Sciences 45 (2003) 75–82

T T 1/2

1 V
k 2 (t) 5 ln ]] 1 ]
1
BbT (t) 2
E s (t) dt2Y1E s (t) dt2
2 2
.
t t

However, uniqueness of V * is not guaranteed under the assumption of stochastic interest

rate, which makes Geske’s approach scarcely helpful in the more general case.

References

Brealey, R., Myerss, S.C., 1991. In: Principles of Corporate Finance. McGraw-Hill, New York.
Carr, P., 1988. The valuation of sequential exchange opportunities. Journal of Finance 5, 1235–1256.
´
Geman, H., El Karoui, Rochet, J.C., 1995. Changes of numeraire, changes of probability measure and option
pricing. Journal of Applied Probability 32, 443–458.
Geske, R., 1979. The valuation of compound options. Journal of Financial Economics 7, 63–81.
Geske, R., Johnson, H.E., 1984. The valuation of corporate liabilities as compound options: a correction.
Journal of Financial and Quantitative Analysis 19 (2), 231–232.
Merton, R.C., 1973. Theory of rational option pricing. Bell Journal of Economics 4, 141–183.
Trigeorgis, L., 1996. In: Real Options. Managerial Flexibility and Strategy in Resource Allocation. MIT Press,
Cambridge, MA.