Exoticoptions

Chapter 8
Exotic Options
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 dBt , t ∈ R+ ,
where (Bt )t∈R+ is a standard Brownian motion under the risk-neutral prob-
ability measure P∗ . In particular the value Vt of a self-financing portfolio
satisfies wT
VT e−rT = V0 + σ ξt St e−rt dBt , t ∈ [0, T ].
0
8.1 Generalities
An exotic option is an option whose payoff may depend on the whole path
{St : t ∈ [0, T ]} of the price process via a “complex” operation such as
averaging or computing a maximum. They are opposed to vanilla options
whose payoff
C = φ(ST ),
where φ is called a payoff function, depends only on the terminal value ST of
the price process.
An option with payoff C = φ(ST ) can be priced as

w∞
e−rT IE[φ(ST )] = e−rT φ(y)fST (y)dy
−∞
where fST (y) is the (one parameter) probability density function of ST , which
satisfies wy
P(ST ≤ y) = fST (v)dv, y ∈ R.
−∞
"
N. Privault
Recall that typically we have


x − K if x ≥ K,
+
φ(x) = (x − K) =
0 if x < K,

for a European call option with strike K, and


 $1 if x ≥ K,
φ(x) = 1[K,∞) (x) =
0 if x < K,

for a binary call option with strike K.
Exotic Options
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 price process instead of its terminal value ST . Next we

review some examples of exotic options.
Options on Extrema
We take
C := φ(MT ),
where
MT = max St
t∈[0,T ]
is the maximum of (St )t∈R+ over the time interval [0, T ].
Figure 8.1 represents the running maximum process (Mt )t∈R+ of Brownian
motion (Bt )t∈R+ .
152 "
This version: April 24, 2013

http://www.ntu.edu.sg/home/nprivault/indext.html
Notes on Stochastic Finance
3
Xt
Bt
2.5
1.5
Bt , X t
0.5
-0.5
-1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 8.1: Brownian motion Bt and its supremum Xt .
Barrier Options
The payoff of an up-and-out barrier put option on the underlying asset St

with exercise date T , strike K and barrier B is
(K − ST )+ if max St < B,

0≤t≤T


+
C = (K − ST ) 1( ) =
max St < B 0

if max St ≥ B.
0≤t≤T 0≤t≤T
This option is also called a Callable Bear Contract with no residual value, in
which the call price B usually satisfies B ≤ K.
The payoff of a down-and-out barrier call option on the underlying asset

St with exercise date T , strike K and barrier B is
(S − K)+ if min St > B,


 T
 0≤t≤T
+
C = (ST − K) 1( ) =
min St > B 0

if min St ≤ B.
0≤t≤T 0≤t≤T
This option is also called a Callable Bull Contract with no residual value, in
which B denotes the call price B ≥ K. It is also called a turbo warrant with
no rebate.
" 153

N. Privault
Lookback Options
The payoff of a floating strike lookback call option on the underlying asset
St with exercise date T is
C = ST − min St .
0≤t≤T
The payoff of a floating strike lookback put option on the underlying asset
St with exercise date T is

C = max St − ST .
0≤t≤T
Options on Average
In this case we can take

1 wT

C=φ St dt
T 0
where
1 wT
St dt
T 0
represents the average of (St )t∈R+ over the time interval [0, T ] and φ : R −→ R
is a payoff function.
3
Xt
Bt
2.5
1.5
Bt , X t
0.5
-0.5
-1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 8.2: Brownian motion Bt and its moving average.
154 "

Figure 8.2 shows a graph of Brownian motion and its moving average process
Xt .
Asian Options
Asian options are particular cases of options on average, and they were first
traded in Tokyo in 1987. The payoff of the Asian call option on the underlying
asset St with exercise date T and strike K is given by
1 wT
+
C= St dt − K .
T 0
Similarly, the payoff of the Asian put option on the underlying asset St with
exercise date T and strike K is
1 wT
+
C= K− St dt .
T 0
Due to the fact that their dependence on averaged asset prices, Asian op-
tions are less volatile than plain vanilla options whose payoffs depend only
on the terminal value of the underlying asset. Asian options have become
particularly popular in commodities trading.
8.2 The Reflexion Principle
In order to price barrier options we will have to derive the probability density
of the maximum
MT = max St
t∈[0,T ]
of geometric Brownian motion (St )t∈R+ over a given time interval [0, T ].
In such situations the option price at time t = 0 can be expressed as

w∞ w∞
e−rT IE[φ(MT , ST )] = e−rT φ(x, y)f(MT ,ST ) (x, y)dxdy
−∞ −∞
where f(MT ,ST ) is the joint probability density function of (MT , ST ), which
satisfies
wx wy
P(MT ≤ x, ST ≤ y) = f(MT ,ST ) (u, v)dudv, x, y ∈ R.
−∞ −∞
In order to price such options by the above probabilistic method, we will

compute f(MT ,ST ) (u, v) by the reflection principle.
" 155

N. Privault
Maximum of Standard Brownian Motion
Let (Bt )t∈R+ denote a standard Brownian motion started at B0 = 0. While

it is well-known that BT ' N (0, T ), computing the law of the maximum
XT = max Bt
t∈[0,T ]
might seem a difficult problem. However this is not the case, due to the
reflection principle. Note that since B0 = 0 we have
XT ≥ 0,
almost surely.
Given a > B0 = 0, let
τa = inf{t ∈ R+ : Bt = a}
denote the first time (Bt )t∈R+ hits the level a > 0.
Due to the space symmetry of Brownian motion we have the identity

1
P(BT > a | τa < T ) = = P(BT < a | τa < T ).
2
This identity is clearly equivalent to
2P(BT > a & τa < T ) = P(τa < T ) = 2P(BT < a & τa < T ),
and to
2P(BT > a & XT ≥ a) = P(τa < T ) = 2P(BT < a & XT ≥ a),
due to the equivalence
{XT ≥ a} = {τa < T }. (8.1)
In other words, we have
P(XT ≥ a) = P(BT > a & XT ≥ a) + P(BT < a & XT ≥ a)

= 2P(BT > a & XT ≥ a)
= 2P(BT > a)
156 "

= P(BT > a) + P(BT < −a)

= P(|BT | > a),
where we used the fact that
{BT > a} ⊂ {BT > a & XT ≥ a} ⊂ {BT > a}.
Figure 8.3 shows a graph of Brownian motion and its reflected path.
2.5
1.5
1
Bt
0.5
-0.5
-1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 8.3: Reflected Brownian motion with a = 1.
Consequently, the maximum XT of Brownian motion has same distribution as

the absolute value |BT | of BT . In other words, XT is a non-negative random
variable with distribution function
P(XT ≤ a) = P(|BT | ≤ a)
1 w a −x2 /(2T )
= √ e dx
2πT −a
2 w a 2
= √ e−x /(2T ) dx, a ∈ R+ ,
2πT 0
and probability density
r
dP(XT ≤ a) 2 −a2 /(2T )
fXT (a) = = e 1[0,∞) (a), a ∈ R. (8.2)
da πT
" 157

N. Privault
1
Density function
0.8
0.6
density
0.4
0.2
0
-4 -3 -2 -1 0 1 2 3 4
x
Fig. 8.4: Probability density of the maximum of Brownian motion over [0, 1].
Using the density of XT we can price an option with payoff φ(XT ), as

w∞
e−rT IE [φ(XT )] = e−rT φ(x)dP(XT = x)
−∞
2 w∞
r
2
= e−rT φ(x)e−|x| /(2T ) dx.
πT 0
Next we consider
MT = max St
t∈[0,T ]
= S0 max eσBt
t∈[0,T ]
= S0 eσ maxt∈[0,T ] Bt
= S0 eσXT ,
since σ > 0. When the payoff takes the form
C = φ(MT ),
where
ST = S0 eσBT ,
we have
C = φ(MT ) = φ(S0 eσXT ),
hence
e−rT IE [C] = e−rT IE φ(S0 eσXT )

w∞
= e−rT φ(S0 eσx )dP(XT = x)
−∞
158 "

2 −rT w ∞
r
2
= e φ(S0 eσx )e−x /(2T ) dx.
πT 0
This however is not sufficient since this imposes the condition r = σ 2 /2. In
order to do away with this condition we need to consider the maximum of
drifted Brownian motion, and for this we have to compute the joint density
of XT and BT .
Joint Density
The reflection principle also allows us to compute the joint density of Brow-
nian motion BT and its maximum XT . Indeed, for b ∈ [0, a] we also have
P(BT > a + (a − b) | τa < T ) = P(BT 2a − b & τa < T ) = P(BT 2a − b & XT ≥ a) = P(BT 2a − b & XT ≥ a) = P(BT 2a − b & XT ≥ 2a − b}

⊂ {BT > 2a − b & XT ≥ a} ⊂ {BT > a},
which shows that {BT ≥ 2a − b} = {BT > 2a − b & XT ≥ a}.
Hence by (8.3) we have

1 w ∞ −x2 /(2T )
P(BT < b & XT ≥ a) = P(BT ≥ 2a − b) = √ e dx,
2πT 2a−b
0 ≤ b ≤ a, which yields the joint probability density
dP(XT ≥ a & BT ≤ b) dP(XT ≤ a & BT ≤ b)

fXT ,BT (a, b) = − = ,
dadb dadb
" 159

N. Privault
a, b ∈ R, by (16.15), i.e., letting a ∨ b := max(a, b),
r
2 (2a − b) −(2a−b)2 /(2T )
fXT ,BT (a, b) = e 1{a≥b∨0} (8.4)
πT T
r
2 (2a − b) −(2a−b)2 /(2T )
a > b ∨ 0,


 e ,
= πT T


0, a < b ∨ 0.

Density function
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0-1
-0.5
0
0.5 -0.5 -1
1 0
b 1.5 0.5
2 1.5 1
2.5 2 a
3 3 2.5
Fig. 8.5: Joint probability density of B1 and its maximum over [0,1].
Maximum of Drifted Brownian Motion
Using the Girsanov theorem, it is even possible to compute the probability

density function of the maximum
X̃T = max B̃t = max (Bt + µt)

t∈[0,T ] t∈[0,T ]
of the drifted Brownian motion B̃t = Bt + µt, µ ∈ R. The arguments previ-

ously applied to Bt cannot be directly applied to B̃t because drifted Brownian
motion is no longer symmetric in space when µ 6= 0.
On the other hand, B̃t is a standard Brownian motion under the proba-
bility measure P̃ defined from
160 "

dP̃ 2
= e−µBT −µ T /2 , (8.5)
dP
hence the density of X̃T under P̃ is given by (8.4).
Now, using the density (8.5) we get

h i
P(X̃T ≤ a & B̃T ≤ b) = IE 1{X̃T ≤a & B̃T ≤b}
h i
˜ eµBT +µ2 T /2 1
= IE {X̃T ≤a & B̃T ≤b}
h i
˜ eµB̃T −µ2 T /2 1
= IE {X̃T ≤a & B̃T ≤b}
2 wawb
r
2 (2x − y) −(2x−y)2 /(2T )
= 1(−∞,x] (y)eµy−µ T /2 e dxdy,
πT 0 −∞ T
0 ≤ b ≤ a, which yields the joint probability density
dP(X̃T ≤ a & B̃T ≤ b)

fX̃T ,B̃T (a, b) = ,
dadb
i.e.
r
1 2 2 2
fX̃T ,B̃T (a, b) = 1{a≥b∨0} (2a − b)eµb−(2a−b) /(2T )−µ T /2 (8.6)
T πT
 r
1 2 2 2
(2a − b)e−µ T /2+µb−(2a−b) /(2T ) , a > b ∨ 0,



= T πT


0, a < b ∨ 0.

We also find
2 waw∞
r
2 (2x − y) −(2x−y)2 /(2T )
P(X̃T ≤ a) = 1(−∞,x] (y)eµy−µ T /2 e dydx
πT 0 −∞ T
r
2 −µ2 T /2 w a w a (2x − y) −(2x−y)2 /(2T )
= e eµy e dxdy
πT −∞ y∨0 T
1 −µ2 T /2 w a
r
2 2
= e eµy−(2(y∨0)−y) /(2T ) − eµy−(2a−y) /(2T ) dy
2πT −∞
1 w a µy−y2 /(2T )−µ2 T /2

r
2 2 2
= e − eµy−2a /T +2ay/T −y /(2T )−µ T /2 dy
2πT −∞
" 161

N. Privault
1 w a −(y−µT )2 /(2T )
r
2
= e − e−(y−(µT +2a)) /(2T )+2aµ dy
2πT −∞
1 w a −(y−µT )2 /(2T ) 1 w a −(y−(µT +2a))2 /(2T )
r r
= e dy − e2aµ e dy
2πT −∞ 2πT −∞
1 w a−µT −y2 /(2T ) 1 w −a−µT −y2 /(2T )
r r
= e dy − e2aµ e dy
2πT −∞ 2πT −∞
a − µT −a − µT

=Φ √ − e2µa Φ √ , (8.7)
T T
cf. Corollary 7.2.2 and pages 297-299 of [71] for another derivation. This
yields the density
r
dP(X̃T ≤ a) −a − µT

2 −(a−µT )2 /(2T )
= e − 2µe2µa Φ √ ,
da πT T
of the supremum of drifted Brownian motion, and recovers (8.2) for µ = 0.
µ=0
1.4 µ=-0.5
µ=0.5
1.2
1
density
0.8
0.6
0.4
0.2
0
-1 0 1 2 3 4
x
Fig. 8.6: Probability density of the maximum of drifted Brownian motion.
Note from Figure 8.2 that small values of the maximum are more likely to
occur when µ takes large negative values.
Based on the relation min B̃t = − max (−B̃t ), the joint density fR̃T ,B̃T
t∈[0,T ] t∈[0,T ]
of the minimum
R̃T = min B̃t = min (Bt + µt)
t∈[0,T ] t∈[0,T ]
of the drifted Brownian motion B̃t := Bt + µt and its value B̃T at time T
can similarly be computed as follows, letting a ∧ b := min(a, b):
162 "

r
1 2 2 2
fR̃T ,B̃T (a, b) = 1{a≤b∧0} (b − 2a)eµb−(2a−b) /(2T )−µ T /2 (8.8)
T πT
 r
1 2 2 2
(b − 2a)e−µ T /2+µb−(2a−b) /(2T ) , a b ∧ 0.

8.3 Barrier Options
General Case
Using the joint density of B̃T and X̃T we are able to price any exotic option
with payoff φ(B̃T , X̃T ), as
" #
e−r(T −t) IE φ(X̃T , B̃T ) Ft ,
with in particular
h i w∞ w∞
e−rT IE φ(X̃T , B̃T ) = e−rT φ(x, y)dP(X̃T = x, B̃T = y).
−∞ y∨0
When the payoff takes the form
C = φ(MT , ST ),
where 2
ST = S0 eσBT −σ T /2+rT
= S0 eσB̃T ,
with µ = −σ/2 + r/σ and B̃T = BT + µT , and
MT = max St
t∈[0,T ]
2
= S0 max eσBt −σ t/2+rt
t∈[0,T ]
= S0 max eσB̃t
t∈[0,T ]
= S0 eσ maxt∈[0,T ] B̃t
= S0 eσX̃T ,
" 163

N. Privault
we have
C = φ(ST , MT )
2
= φ(S0 eσBT −σ T /2+rT
, MT )
= φ(S0 eσB̃T , S0 eσX̃T ),
hence
h i
e−rT IE[C] = e−rT IE φ(S0 eσB̃T , S0 eσX̃T )
w∞ w∞
= e−rT φ(S0 eσy , S0 eσx )dP(X̃T = x, B̃T = y)
−∞ y∨0
2 −rT w ∞ w ∞
r
1 2 2
= e φ(S0 eσy , S0 eσx )(2x − y)e−µ T /2+µy−(2x−y) /(2T ) dxdy
T πT −∞ y∨0
2 w∞w∞
r
1 2 2
= e−rT φ(S0 eσy , S0 eσx )(2x − y)e−µ T /2+µy−(2x−y) /(2T ) dxdy
T πT 0 y
2 w0 w∞
r
1 2 2
+ e−rT φ(S0 eσy , S0 eσx )(2x − y)e−µ T /2+µy−(2x−y) /(2T ) dxdy.
T πT −∞ 0
We can distinguish 8 different versions of barrier options according to the
following table.
164 "

option type behavior payoff
+
down-and-out (ST − K) 1( )
min St > B
0≤t≤T
+
down-and-in (ST − K) 1( )
min St B
0≤t≤T
+
down-and-out (K − ST ) 1( )
min St > B
0≤t≤T
+
down-and-in (K − ST ) 1( )
min St B
0≤t≤T
We have the following obvious relations between the prices of barrier and
vanilla call and put options:
Cup−in (t) + Cup−out (t) = C(t) = e−r(T −t) IE∗ [(ST − K)+ ],
Cdown−in (t) + Cdown−out (t) = C(t) = e−r(T −t) IE∗ [(ST − K)+ ],
" 165

N. Privault
Pup−in (t) + Pup−out (t) = P (t) = e−r(T −t) IE∗ [(K − ST )+ ],
Pdown−in (t) + Pdown−out (t) = P (t) = e−r(T −t) IE∗ [(K − ST )+ ],
where C(t), resp. P (t) denotes the price of a European call, resp. put option
with strike K as obtained from the Black-Scholes formula. Consequently, in
the sequel we will only compute the prices of the up-and-out call and put,
and down-and-out barrier call and put options.
Up-and-Out Barrier Call Option
Let us consider an up-and-out call option with maturity T , strike K, barrier

(or call price) B, and payoff
S −K if max St ≤ B,

 T
 0≤t≤T
+
C = (ST − K) 1( ) =
max St ≤ B 0

if max St > B,
0≤t≤T 0≤t≤T
with B > K. Our goal is to prove the following result.

Proposition 8.1. When K < B, the price
 
+
−r(T −t) ∗ ST −t
e 1{Mt ≤ B } IE  x −K 1( )
S0

x max Sr /S0 ≤ B
0≤r≤T −t
x=St
of the up-and-out call option with maturity T , strike K and barrier B is given
by
e−r(T −t) IE∗ [C | Ft ] (8.9)

T −t St T −t S t
= St 1{Mt ≤ B } Φ δ+ − Φ δ+
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−r(T −t) K1{Mt ≤ B } Φ δ− − Φ δ−
K B
1−2r/σ2 2 !
St T −t B T −t B
− Φ δ− − Φ δ− ,
B KSt St
where
166 "


τ 1 1
δ± (s) = √ log s + r ± σ 2 τ , s > 0. (8.10)
σ τ 2
Note that taking B = +∞ in the above identity (8.9) recovers the Black-
Scholes formula for the price of a European call option, and that the price of
the up-and-out barrier call option is 0 when B < K.
The following graph represents the up-and-out call option price given the
value St of the underlying and the time t ∈ [0, T ] with T = 220 days.
up and out call price

Option price path
16
14
12
10
8
6
4
2
0
220
200
180
160 Time in days
140
50 55 60 65 70 120
75 80 100
85 90
underlying
Fig. 8.7: Graph of the up-and-out call option price.
Proof of Proposition 8.1. We have C = φ(ST , MT ) with


 x − K if y ≤ B,
+
φ(x, y) = (x − K) 1{y≤B} =
0 if y > B,

hence
" #
+
e−r(T −t) IE∗ [C | Ft ] = e−r(T −t) IE∗ (ST − K) 1{MT ≤B} Ft
" #
−r(T −t) ∗ +
=e IE (ST − K) 1{MT ≤ B } Ft
 
+
= e−r(T −t) IE∗ (ST − K) 1{Mt ≤ B } 1( Ft 
 ) 
max Sr ≤ B
t≤r≤T
" 167

N. Privault
 
−r(T −t) ∗ +
=e 1{Mt ≤ B } IE (ST − K) 1( Ft 
 ) 
max Sr ≤ B
t≤r≤T
 
+
−r(T −t) ∗ ST
=e 1{Mt ≤ B } IE  x −K 1( )
St

x max Sr /St ≤ B
t≤r≤T
x=St
 
+
 ST −t
= e−r(T −t) 1{Mt ≤ B } IE∗  x −K 1( ) .
S0

x max Sr /S0 ≤ B
0≤r≤T −t
x=St
It suffices to compute
h i
+
e−rτ IE∗ [C] = e−rτ IE∗ (Sτ − K) 1{Mτ ≤B}
+
= e−rτ IE∗ S0 eσB̃τ − K 1{S0 eσX̃τ ≤B}
w∞ w∞
+
= e−rτ (S0 eσy − K) 1{S0 eσx ≤B} dP(X̃τ = x, B̃τ = y)
−∞ y∨0
2 −rτ w σ−1 log(B/S0 )

r
1
= e
τ πτ −∞
w∞ 2 2
+
(S0 eσy − K) 1{S0 eσx ≤B} (2x − y)e−µ τ /2+µy−(2x−y) /(2τ ) dxdy
y∨0
2 w σ−1 log(B/S0 )
r
1
= e−rτ
τ πτ 0
w∞ 2 2
+
y
2 w0
r
1
+ e−rτ
τ πτ −∞
w∞ 2 2
+
0
2 w σ−1 log(B/S0 )
r
1
= e−rτ
τ πτ 0
w∞ 2 2
+
(S0 eσy − K) 1{x≤σ−1 log(B/S0 )} (2x − y)e−µ τ /2+µy−(2x−y) /(2τ ) dxdy
y
2 w0
r
1
+ e−rτ
τ πτ −∞
w∞ 2 2
+
(S0 eσy − K) 1{x≤σ−1 log(B/S0 )} (2x − y)e−µ τ /2+µy−(2x−y) /(2τ ) dxdy
0
2 w σ−1 log(B/S0 )
r
1
= e−rτ
τ πτ 0
168 "

w σ−1 log(B/S0 ) 2
+ τ /2+µy−(2x−y)2 /(2τ )
(S0 eσy − K) (2x − y)e−µ dxdy
y
2 w0
r
1
+ e−rτ
τ πτ −∞
w σ−1 log(B/S0 ) 2
+ τ /2+µy−(2x−y)2 /(2τ )
(S0 eσy − K) (2x − y)e−µ dxdy
0
2 w σ−1 log(B/S0 )
r
1 −rτ
= e
τ πτ σ−1 log(K/S0 )
w σ−1 log(B/S0 ) 2 2
(S0 eσy − K) (2x − y)e−µ τ /2+µy−(2x−y) /(2τ ) dxdy
y∨0
2 w σ−1 log(B/S0 )
r
1 2 2
= e−rτ −µ τ /2 (S0 eσy − K) eµy−y /(2τ )
τ πτ σ−1 log(K/S0 )
w σ−1 log(B/S0 )
(2x − y)e2x(y−x)/τ dxdy,
y∨0
if 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)e2x(y−x)/τ dx = (2x − y)e2x(y−x)/τ dx
a a
τh ix=b
= − e2x(y−x)/τ
2 x=a
τ 2a(y−a)/τ
= (e − e2b(y−b)/τ )
2
τ 2(y∨0)(y−y∨0)/τ
= (e − e2b(y−b)/τ )
2
τ
= (1 − e2b(y−b)/τ ),
2
hence, letting c = σ −1 log(K/S0 ), we have
2 1 wb 2
e−rτ IE∗ [C] = e−τ (r+µ /2)
(S0 eσy − K) eµy−y /(2τ ) (1 − e2b(y−b)/τ )dy
√
2πτ c
2 1 w b y(σ+µ)−y2 /(2τ )
= S0 e−τ (r+µ /2) √ e (1 − e2b(y−b)/τ )dy
2πτ c
2 1 w b µy−y2 /(2τ )
−Ke−τ (r+µ /2) √ e (1 − e2b(y−b)/τ )dy
2πτ c
2 1 w b y(σ+µ)−y2 /(2τ )
= S0 e−τ (r+µ /2) √ e dy
2πτ c
2 2 1 w b 2
−S0 e−τ (r+µ /2)−2b /τ √ ey(σ+µ+2b/τ )−y /(2τ ) dy
2πτ c
" 169

N. Privault
2 1 w b µy−y2 /(2τ )
−Ke−τ (r+µ /2)
√e dy
2πτ c
2 2 1 w b 2
+Ke−τ (r+µ /2)−2b /τ √ ey(µ+2b/τ )−y /(2τ ) dy.
2πτ c
Using the relation
1 w b γy−y2 /(2τ ) −c + γτ −b + γτ

2
√ e dy = eγ τ /2 Φ √ −Φ √ ,
2πτ c τ τ
we find
h i
+
e−rτ IE∗ [C] = e−rT IE∗ (ST − K) 1{MT ≤B}
−c + (σ + µ)τ −b + (σ + µ)τ

2 2
= S0 e−τ (r+µ /2)+(σ+µ) τ /2 Φ √ −Φ √
τ τ
2 2 2
−S0 e−τ (r+µ /2)−2b /τ +(σ+µ+2b/τ ) τ /2
−c + (σ + µ + 2b/τ )τ −b + (σ + µ + 2b/τ )τ

× Φ √ −Φ √
τ τ
−c −b

+ µτ + µτ
−Ke−rτ Φ √ −Φ √
τ τ
2 2 2
+Ke−τ (r+µ /2)−2b /τ +(µ+2b/τ ) τ /2
−c + (µ + 2b/τ )τ −b + (µ + 2b/τ )τ

× Φ √ −Φ √
τ τ

τ S0 τ S0
= S0 Φ δ+ − Φ δ+
K B
2
−τ (r+µ2 /2)−2b2 /τ +(σ+µ+2b/τ )2 τ /2 τ B τ B
−S0 e Φ δ+ − Φ δ+
KS0 S0

S0 S0
−Ke−rτ Φ δ− τ
− Φ δ− τ
K B
2
−τ (r+µ2 /2)−2b2 /τ +(µ+2b/τ )2 τ /2 B B
+Ke Φ δ− − Φ δ− ,
KS0 S0
τ
0 ≤ x ≤ B, where δ± (s) is defined in (8.10). Given the relations
−τ (r+µ2 /2)−2b2 /τ +(σ+µ+2b/τ )2 τ /2 = 2b(r/σ+σ/2) = (1+2r/σ 2 ) log(B/S0 ),
and
−τ (r+µ2 /2)−2b2 /τ +(µ+2b/τ )2 τ /2 = −rτ +2µb = −rτ +(−1+2r/σ 2 ) log(B/S0 ),
this yields
h i
+
e−rτ IE∗ [C] = e−rτ IE∗ (Sτ − K) 1{Mτ ≤B} (8.11)
170 "


τ S0 τ S0
= S0 Φ δ+ − Φ δ+
K B

−rτ τ S0 τ S0
−e K Φ δ− − Φ δ−
K B
2r/σ2 2
B τ B τ B
−B Φ δ+ − Φ δ+
S0 KS0 S0
1−2r/σ2 2
S0 B B
+e−rτ K Φ δ− τ
− Φ δ− τ
B KS0 S0

τ S0 τ S0
= S0 Φ δ+ − Φ δ+
K B
1+2r/σ2 2
B τ B τ B
−S0 Φ δ+ − Φ δ+
S0 KS0 S0

S0 S0
−e−rτ K Φ δ− τ
− Φ δ− τ
K B
1−2r/σ2 2
S0 B B
−e−rτ K Φ δ− τ
− Φ δ− τ
,
B KS0 S0
and this yields the result of Proposition 8.1, cf. § 7.3.3 pages 304-307 of [71]
for a different calculation. This concludes the proof of Proposition 8.1.
Up-and-Out Barrier Put Option
The price
 
+
−r(T −t) ∗ ST −t
e 1{Mt ≤ B } IE  K − x 1(
 )
S0

x max Sr /S0 ≤ B
0≤r≤T −t
x=St
of the up-and-out put option with maturity T , strike K and barrier B is

given by
e−r(T −t) IE∗ [P | Ft ]

T −t St
= St 1{Mt ≤ B } Φ δ+ −1
K
1+2r/σ 2 2 !
B T −t B
− Φ δ+ −1
St KSt

T −t St
−e−r(T −t) K1{Mt ≤ B } Φ δ− −1
K
" 171

N. Privault
1−2r/σ2 2 !
St T −t B
− Φ δ− −1
B KSt
1+2r/σ2 2 !
T −t St B T −t B
= St 1{Mt ≤ B } −Φ −δ+ + Φ −δ+
K St KSt
−Ke−r(T −t)
1−2r/σ2 2 !
T −t St St T −t B
×1{Mt ≤ B } −Φ −δ− + Φ −δ− ,
K B KSt
if B > K, and

St
e−r(T −t) IE∗ [P | Ft ] = St 1{Mt ≤ B } Φ δ+ T −t
−1
B
1+2r/σ2 !
B T −t B
− Φ δ+ −1
St St

T −t St
−e−r(T −t) K1{Mt ≤ B } Φ δ− −1
B
1−2r/σ 2 !
St T −t B
− Φ δ− −1
B St
1+2r/σ2 !
T −t St B T −t B
= St 1{Mt ≤ B } −Φ −δ+ + Φ −δ+
B St St
−Ke−r(T −t)
1−2r/σ2 !
T −t St St T −t B
×1{Mt ≤ B } −Φ −δ− + Φ −δ− ,
B B St
(8.12)
if B < K.
172 "

up and out put price
12
10
4 220
200
2 180
160 Time in days
0 50 140
55 60 65 120
70 75 80 85 90 100
-2 underlying
Fig. 8.8: Graph of the up-and-out put option price with B > K.
up and out put price
50
45
40
35
30
25
20
15 220
10 200
180
5 160 Time in days
0 50 140
55 60 120
65 70 75 80
underlying
85 90 100
Fig. 8.9: Graph of the up-and-out put option price with K > B.
Down-and-Out Barrier Call Option
Let us now consider a down-and-out barrier call option on the underlying

asset St with exercise date T , strike K, barrier B, and payoff
S −K if min St > B,

 T
 0≤t≤T
+
C = (ST − K) 1( ) =
min St > B 0

if min St ≤ B,
0≤t≤T 0≤t≤T
with 0 ≤ B ≤ K. This option is also called a Callable Bull Contract with no

residual value, in which B denotes the call price, or a turbo warrant with no
rebate.
" 173

N. Privault
We have
e−r(T −t) IE∗ [C | Ft ]

T −t St T −t St
= g(t, St ) = St Φ δ+ − e−r(T −t) KΦ δ− (8.13)
K K
2r/σ2 2
B T −t B
−B Φ δ+
St Kx
1−2r/σ2 2
St T −t B
+e−r(T −t) K Φ δ− (8.14)
B KSt
= BSc (St , r, T − t, K)
2r/σ2 2
B T −t B
−B Φ δ+
St KSt
1−2r/σ2 2
St T −t B
+e−r(T −t) K Φ δ−
B KSt
1−2r/σ2
1 St
= BSc (St , r, T − t, K) − BSc (B/St , r, T − t, K/B),
B B
St > B, 0 ≤ t ≤ T , and
 
+
IE∗ (ST − K) 1( Ft  = 1{mint∈[0,T ] St >B} g(t, St ),
 ) 
min St > B
0≤t≤T
t ∈ [0, T ]. When B > K we find
e−r(T −t) IE∗ [C | Ft ] = g(t, St )

T −t St T −t St
= St Φ δ+ − e−r(T −t) KΦ δ−
B B
2r/σ2
B T −t B
−B Φ δ+
St St
1−2r/σ2
St T −t B
+e−r(T −t) K Φ δ− , (8.15)
B St
St > B, 0 ≤ t ≤ T , cf. Exercise 8.3 below.
174 "

down and out call price
1.6
1.4
1.2
0.8
0.6
140
0.4 135
130
125
0.2 120 Time in days
115
0 50 110
55 60 105
65 70 75 80 85 90 100
underlying
Fig. 8.10: Graph of the down-and-out call option price with B < K.
down and out call price
60
50
40
30
20
220
200
10 180
160 Time in days
0 50 140
55 60 120
65 70 75 80
underlying
85 90 100
Fig. 8.11: Graph of the down-and-out call option price with K > B.
Down-and-Out Barrier Put Option
When B > K, the price

 
+
−r(T −t) ∗ ST −t
e 1{mt ≥ B } IE  K − x 1(
 )
S0

x min Sr /S0 ≥ B
0≤r≤T −t
x=St
of the down-and-out put option with maturity T , strike K and barrier B is

given by
" 175

N. Privault
e−r(T −t) IE∗ [P | Ft ] (8.16)

T −t St T −t St
= St 1{mt ≥ B } Φ δ+ − Φ δ+
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−r(T −t) K1{mt ≥ B } Φ δ− − Φ δ−
K B
1−2r/σ2 2 !
St T −t B T −t B
+ Φ δ− − Φ δ− ,
B KSt St
while the corresponding price vanishes when B < K.
down and out put price
14
12
10
6
220
4
200
2 180
160 Time in days
0 50 140
55 60 120
65 70
-2 75 80
underlying
85 90 100
Fig. 8.12: Graph of the down-and-out put option price with K > B.
Note that although Figures 8.8 and 8.10, resp. 8.9 and 8.11, appear to share
some symmetry property, the functions themselves are not exactly symmetric.
Concerning 8.7 and 8.12 the pricing function is actually the same, but the
conditions B < K and B > K play opposite roles.
PDE Method
Having computed the up-and-out call option price by probabilistic arguments,

we are now interested in deriving a PDE for this price.
The option price can be written as

" #
+
e−r(T −t) IE∗ (ST − K) 1{MT ≤B} Ft
176 "

 
= e−r(T −t) 1( ) IE (S − K)+ 1(

∗ ) Ft 

 T
max Sr ≤ B max Sr ≤ B
0≤r≤t t≤r≤T
= g(t, St , Mt ),
where the function g(t, x) of t and St is given by

 
+
g(t, x, y) = 1{y≤B} e−r(T −t) IE∗ (ST − K) 1( St = x .
 ) 
max Sr ≤ B
t≤r≤T
(8.17)
Next, by the same argument as in the proof of Proposition 5.2 we derive the
Black-Scholes partial differential equation (PDE) satisfied by g(t, x), for the
price of a self-financing portfolio.
Proposition 8.2. Let (ηt , ξt )t∈R+ be a portfolio strategy such that
(i) (ηt , ξt )t∈R+ is self-financing,
(ii) the value Vt := ηt At + ξt St , t ∈ R+ , takes the form
Vt = g(t, St , Mt ), t ∈ R+ .
Then the function g(t, x, y) satisfies the Black-Scholes PDE
∂g ∂g 1 ∂2g
rg(t, x, y) = (t, x, y) + ry (t, x, y) + x2 σ 2 2 (t, x, y), (8.18)
∂t ∂x 2 ∂x
t > 0, x > 0, 0 < y < B, and ξt is given by
∂g
ξt = (t, St , Mt ), t ∈ [0, T ], (8.19)
∂x
provided Mt < B.
Proof. By (8.17) the price at time t of the down-and-out call barrier option
discounted to time 0 is given by
 
+
e−rt g(t, St , Mt ) = 1{Mt ≤B} e−rT IE∗ (ST − K) 1( St = x
 ) 
max Sr ≤ B
t≤r≤T
 
−rT ∗ +
=e IE (ST − K) 1{Mt ≤B} 1( St = x
 ) 
max Sr ≤ B
t≤r≤T
" 177

N. Privault
 
−rT ∗ +
=e IE (ST − K) 1( St = x ,
 ) 
max Sr ≤ B
0≤r≤T
which is a martingale. We conclude by applying the Itô formula to t 7→

e−rt g(t, St , Mt ) “on {Mt ≤ y, 0 ≤ t ≤ T }” and noting that the sum of
components in factor of dt vanishes.
In the sequel we will drop the variable y in g(t, x, y) and simply write g(t, x)
since
∂g
(t, x, y) = 0, 0 < y < B,
∂y
and the function g(t, x, y) is constant in y ∈ (0, B).
In the next proposition we add a boundary condition to the Black-Scholes

PDE (8.18) in order to hedge the up-and-out call option with maturity T ,
strike K, barrier (or call price) B, and payoff
S −K if max St ≤ B,

 T
 0≤t≤T
+
C = (ST − K) 1( ) =
max St ≤ B 0

if max St > B,
0≤t≤T 0≤t≤T
with B > K.
Proposition 8.3. The price of any self-financing portfolio of the form Vt =
g(t, St ) hedging 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),



 ∂t ∂x 2 ∂x

 g(t, x) = 0, x ≥ B, 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 additional boundary condition
g(t, B) = 0. (8.20)
Condition (8.20) holds since the price of the claim at time t is 0 whenever
St = B, cf. e.g. [23].
178 "

The closed-form solution for this PDE is given by (8.11), as
x x
T −t T −t
g(t, x) = x Φ δ+ − Φ δ+ (8.21)
K B
x 1−2r/σ2 2
B

B
T −t T −t
−x Φ δ+ − Φ δ+
B Kx x
x x
T −t T −t
−Ke−r(T −t) Φ δ− − Φ δ−
K B
x 1−2r/σ2 2
B

B
T −t T −t
+Ke−r(T −t) Φ δ− − Φ δ− ,
B Kx x
0 < x ≤ B, 0 ≤ t ≤ T .
We note that the expression (8.21) can be rewritten using the standard
Black-Scholes formula

S S
τ
BSc (S, K, r, σ, τ ) = SΦ δ+ − Ke−rτ Φ δ− τ
K K
for the price of a European call option, as

x x
T −t T −t
g(t, x) = BSc (x, K, r, σ, T − t) − xΦ δ+ + e−r(T −t) 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/σ 2 2
−r(T −t) T −t B T −t B
+e K Φ δ− − Φ δ− ,
B Kx x
0 < x ≤ B, 0 ≤ t ≤ T .
Figure 8.13 represents the value of Delta obtained from (8.19) for the
up-and-out call option, cf. Exercise 8.3-(1).
" 179

N. Privault
up and out delta

delta path
1
0.8
0.6 100
0.4 120
0.2
140
0
160
Time in days
180
90 200
85 80 75 70 220
65 60 55 50
underlying
Fig. 8.13: Delta for the up-and-out option.
Checking the Boundary Conditions
For x = B we check that

T −t B T −t

g(t, B) = B Φ δ+ − Φ δ+ (1)
K

T −t B T −t
−e−r(T −t) K Φ δ−

− Φ δ− (1)
K

T −t B T −t

−B Φ δ+ − Φ δ+ (1)
K

−r(T −t) T −t B T −t

+e K Φ δ− − Φ δ− (1)
K
= 0,
and the function g(t, x) is extended to x > B by letting
g(t, x) = 0, x > B.
For x = K and t = T we find
180 "



 +∞ if s > 1,



0
δ± (s) = −∞ × 1{s<1} + ∞ × 1{s>1} = 0 if s = 1,




−∞ if s < 1,

hence when x < K < B we have
g(T, K) = x (Φ (−∞) − Φ (−∞))

−K (Φ (−∞) − Φ (−∞))
2r/σ2
B
−B (Φ (+∞) − Φ (+∞))
x
2r/σ2
B
+K (Φ (+∞) − Φ (+∞))
K
= 0,
when K < x B we obtain
g(T, K) = x (Φ (+∞) − Φ (+∞))

−K (Φ (+∞) − Φ (+∞))
2r/σ2
B
−B (Φ (−∞) − Φ (−∞))
x
2r/σ2
B
+K (Φ (−∞) − Φ (−∞))
K
= 0.
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
" 181

N. Privault
∂g ∂g 1 ∂2g


 rg(t, x) = (t, x) + rx (t, x) + x2 σ 2 2 (t, x),



 ∂t ∂x 2 ∂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, B) = 0 since the
price of the claim at time t is 0 whenever St = B.
8.4 Lookback Options
Let
mts = inf Su
u∈[s,t]
and
Mst = sup Su ,
u∈[s,t]
0 ≤ s ≤ t ≤ T , and let Mts be either mts or Mst . In the lookback option case
the payoff φ(ST , MT0 ) depends not only on the price of the underlying asset
at maturity but it also depends on all price values of the underlying asset
over the period which starts from the initial time and ends at maturity.
The payoff of such of an option is of the form φ(ST , MT0 ) with φ(x, y) =
x − y in the case of lookback call options, and φ(x, y) = y − x in the case of
lookback put options. We let
e−r(T −t) IE∗ [φ(ST , MT0 )|Ft ]
denote the price at time t ∈ [0, T ] of such an option.
The Lookback Put Option
The standard lookback put option gives its holder the right to sell the un-
derlying asset at its historically highest price. In this case the strike is M0T
and the payoff is
C = M0T − ST .
Our goal is to prove the following pricing formula for lookback put options.
Proposition 8.4. The price at time t ∈ [0, T ] of the lookback put option with
payoff M0T − ST is given by
182 "

e−r(T −t) IE∗ [M0T − ST | Ft ]

σ2

T −t St T −t St
= M0t e−r(T −t) Φ −δ− t + St 1 + Φ δ+ t
M0 2r M0
2
t 2r/σ2 t
σ M0 T −t M0
−St e−r(T −t) Φ −δ− − St .
2r St St
Figure 8.14 represents the lookback put price as a function of St and M0t , for
different values of the time to maturity T − t.
T = 7.0000 Lookback put option price

100
80
60
40
20
0
80
60
Mt 40
20
0 0 40 60 80
20
St
Fig. 8.14: Graph of the lookback put option price.
Proof of Proposition 8.4. We have
IE∗ [M0T − ST | Ft ] = IE∗ [M0T | Ft ] − IE∗ [ST | Ft ]

= IE∗ [M0T | Ft ] − er(T −t) St ,
and
IE∗ [M0T | Ft ] = IE∗ [M0t ∨ MtT | Ft ]

= IE∗ [M0t 1{M0t >MtT } | Ft ] + IE∗ [MtT 1{MtT >M0t } | Ft ]
= M0t IE∗ [1{M0t >MtT } | Ft ] + IE∗ [MtT 1{MtT >M0t } | Ft ]
= M0t P(M0t > MtT | Ft ) + IE∗ [MtT 1{MtT >M0t } | Ft ].
Next, we have
" 183

N. Privault
!
M0t MT
P(M0t > MtT | Ft ) = P > t Ft
St St
!
MT
=P x> t Ft
St
x=M0t /St
!
M0T −t
=P <x .
S0
x=M0t /St
On the other hand, letting µ := r/σ − σ/2, from (8.7) we have

τ
M0
P < x = P(X̃τ < σ −1 log x)
S0
−µτ + σ −1 log x −µτ − σ −1 log x

−1
=Φ √ − e2µσ log x Φ √
τ τ
2
τ
(1/x) − x−1+2r/σ Φ −δ− τ

= Φ −δ− (x) .
Hence
!
M0T −t
P(M0t > MtT ) =P <x
S0
x=M0t /St
−1+2r/σ2
M0t
t
T St T M0
= Φ −δ− − Φ −δ− .
M0t St St
Next, we have
" #
MtT
IE∗ [MtT 1{MtT >M0t } | Ft ] = St IE∗ 1 T t Ft
St {Mt /St >M0 /St }
" #
Sr
= St IE∗ max 1{maxr∈[t,T ] Sr /St >x} Ft
r∈[t,T ] St
x=M0t /St

Sr
= St IE∗ max 1{maxr∈[0,T −t] Sr /S0 >x} ,
r∈[0,T −t] S0 x=M0t /St
and

Sr
IE∗ max 1{maxr∈[0,τ ] Sr /S0 >x}
r∈[0,τ ] S0

= IE∗ max eσB̃r 1{maxr∈[0,τ ] eσB̃r >x}
r∈[0,τ ]
h i
∗
= IE eσ maxr∈[0,τ ] B̃r 1{maxr∈[0,τ ] B̃r >σ−1 log x}
184 "

h i
= IE∗ eσX̃τ 1{X̃τ >σ−1 log x}
w∞
= −1 eσx fX̃τ (z)dz
σ log x
w∞ r
2 −(z−µτ )2 /(2τ )

−z − µτ
!
= −1 eσz e − 2µe2µz Φ √ dz
σ log x πτ τ
2 w∞ w∞
r
−z − µτ

2
= eσz−(z−µτ ) /(2τ ) dz − 2µ −1 ez(σ+2µ) Φ √ dz.
πτ σ −1 log x σ log x τ
By standard arguments we have

1 w∞ 2
√ eσz−(z−µτ ) /(2τ ) dz
2πτ σ−1 log x
1 w∞ 2 2 2
= √ e−(z +µ τ −2(µ+σ)τ z)/(2τ ) dz
2πτ σ−1 log x
1 2
w∞ 2
= √ eσ τ /2+µστ −1 e−(z−(µ+σ)τ ) /(2τ ) dz
2πτ σ log x
1 w∞ 2
= √ erτ e−z /(2τ ) dz
2πτ −(µ+σ)τ +σ −1 log x

1
= erτ Φ δ+τ
,
x
since µσ + σ 2 /2 = r. The second integral

w∞
−z − µτ

ez(σ+2µ) Φ √ dz
σ −1 log x τ
can be computed by integration by parts using the identity

w∞ w∞
v 0 (z)u(z)dz = u(+∞)v(+∞) − u(a)v(a) − v(z)u0 (z)dz,
a a
−1
with a = σ log x. We let
−z − µτ

u(z) = Φ √ and v 0 (z) = ez(σ+2µ)
τ
which satisfy
1 2 1
u0 (z) = − √ e−(z+µτ ) /(2τ ) and v(z) = ez(σ+2µ) ,
2πτ σ + 2µ
and
w∞
−z − µτ
w∞
ez(σ+2µ) Φ √ dz = v 0 (z)u(z)dz
a τ a
" 185

N. Privault
w∞
= u(+∞)v(+∞) − u(a)v(a) − v(z)u0 (z)dz
a
−a − µτ

1
=− ea(σ+2µ) Φ √
σ + 2µ τ
1 w ∞
z(σ+2µ) −(z+µτ )2 /(2τ )
+ √ e e dz
(σ + 2µ) 2πτ a
−a − µτ

1
=− ea(σ+2µ) Φ √
σ + 2µ τ
1 w∞
(τ (σ+µ)2 −µ2 τ )/2 2
+ √ e e−(z−τ (σ+µ)) /(2τ ) dz
(σ + µ) 2πτ a
−a − µτ

1
=− ea(σ+2µ) Φ √
σ + 2µ τ
1 w∞
(τ (σ+µ)2 −µ2 τ )/2 −z 2 /2
+ √ e √ e dz
(σ + 2µ) 2π (a−τ (σ+µ))/ τ
−a − µτ

1
=− ea(σ+2µ) Φ √
σ + 2µ τ
−a + τ (σ + µ)

1 2 2
+ e(τ (σ+µ) −µ τ )/2 Φ √
σ + 2µ τ
−(r/σ − σ/2)τ − σ −1 log x

2r 2r/σ 2
= − (x) Φ √
σ τ
+τ (r/σ + σ/2) − σ −1 log x

2r στ (σ+2µ)/2
+ e Φ √
σ τ

σ rτ τ 1 σ 2r/σ2 τ

= e Φ δ+ − x Φ −δ− (x) ,
2r x 2r
cf. pages 317-319 of [71] for a different derivation using double integrals.
Hence we have
" #
∗ Sr
IE MtT 1{MtT >M0t } Ft = St IE∗ max 1{maxr∈[0,T −t] Sr /S0 >x}
r∈[0,T −t] S0 x=M0t /St

T −t St µσ T −t S t
= 2St er(T −t) Φ δ+ − St er(T −t) Φ δ+
M0t r M0t
2r/σ2
µσ M0t
t
T −t M0
+St Φ −δ− ,
r St St
and consequently this yields, since µσ/r = 1 − σ 2 /(2r),
IE∗ [M0T | Ft ] = IE∗ [M0T | M0t ]

= M0t P(M0t > MtT | M0t ) + IE∗ [MtT 1{MtT >M0t } | M0t ]
186 "

t 2r/σ2 t
T −t St M0 T −t M0
= M0t Φ −δ− t − St Φ −δ−
M0 St St

r(T −t) T −t St
+2St e Φ δ+
M0t
2

σ T −t St
−St 1 − er(T −t) Φ δ+
2r M0t
2
t 2r/σ2 t
σ M0 T −t M0
+St 1 − Φ −δ−
2r St St
σ2

t T −t St r(T −t) T −t St
= M0 Φ −δ− + St e 1 + Φ δ +
M0t 2r M0t
2
t 2r/σ2 t
σ M0 T −t M0
−St Φ −δ− ,
2r St St
hence
e−r(T −t) IE∗ [M0T − ST | Ft ] = e−r(T −t) IE∗ [M0T | Ft ] − e−r(T −t) IE∗ [ST | Ft ]
= e−r(T −t) IE∗ [M0T | M0t ] − St

T −t St T −t St
= M0t e−r(T −t) Φ −δ− t − St Φ −δ+ t
M0 M0
2
2
t 2r/σ2 t
σ T −t St σ −r(T −t) M0 T −t M0
+St Φ δ+ − S t e Φ −δ− .
2r M0t 2r St St
This concludes the proof of Proposition 8.4.
PDE Method
If the couple (St , Mt ) is Markov, the price can be written as a function
f (t, St , Mt ) = e−rT IE∗ [φ(ST , MT ) | Ft ],
and in this case the function f (t, x, y) can solve a PDE.
Next we derive the Black-Scholes partial differential equation (PDE) for

the price of a self-financing portfolio.
Black-Scholes PDE for Lookback Put Options

" 187

N. Privault
(ii) the portfolio value Vt := ηt At + ξt St , t ∈ R+ , takes the form
Vt = f (t, St , M0t ), t ∈ R+ ,
2 2
for some f ∈ C ((0, ∞) × (0, ∞) ).
Then the function f (t, x, y) satisfies the Black-Scholes PDE
∂f ∂f 1 ∂2f
rf (t, x, y) = (t, x, y) + rx (t, x, y) + x2 σ 2 2 (t, x, y), t, x, y > 0,
∂t ∂x 2 ∂x
(8.22)
under the boundary conditions

−r(T −t)
f (t, 0, y) = e
 y, 0 ≤ t ≤ T, y ∈ R+ , (8.23a)






∂f

(t, x, y)x=y = 0, 0 ≤ t ≤ T, y > 0, (8.23b)


 ∂y





f (T, x, y) = y − x, 0 ≤ x ≤ y. (8.23c)

The replicating portfolio of the lookback put option is given by

∂f
ξt = (t, St , M0t ), t ∈ [0, T ], (8.24)
∂x
where f (t, x, y) is given by
f (t, St , M0t ) = e−r(T −t) IE∗ [φ(ST , M0T ) | Ft ], 0 ≤ t ≤ T. (8.25)

Proof. The existence of f (t, x, y) follows from the Markov property, more
precisely the function f (t, x, y) satisfies
f (t, x, y) = e−r(T −t) IE∗ [φ(ST , M0T ) | St = x, M0t = y]

ST y MTt

= e−r(T −t) IE∗ φ x , ∧
St x St
" !#
∗ ST −t y MT0 −t
= e−r(T −t) IE φ x , ∧ , t ∈ [0, T ],
S0 x x
from the time homogeneity of the asset price process (St )t∈R+ . Applying the
change of variable formula to the discounted portfolio value
f˜(t, x, y) = e−rt f (t, x, y) = e−rT IE∗ [φ(ST , M0T ) | St = x, M0t = y]
which is a martingale for t ∈ [0, T ], we have
df˜(t, St , M0t ) = −re−rt f (t, St , M0t )dt + e−rt df (t, St , M0t )
188 "

∂f ∂f
= −re−rt f (t, St , M0t )dt + e−rt (t, St , M0t )dt + re−rt St (t, St , M0t )dt
∂t ∂x
1 ∂2f
+ e−rt σ 2 St2 2 (t, St , M0t )dt
2 ∂x
∂f ∂f
+e−rt (t, St , M0t )dM0t + e−rt σSt (t, St , M0t )dBt .
∂y ∂x
Since IE∗ [φ(ST , M0T ) | Ft ] t∈[0,T ] is a P-martingale and (M0t )t∈[0,T ] has finite

variation (it is in fact a non-decreasing process), we have:
∂f
df (t, St , M0t ) = σSt (t, St , M0t )dBt , t ∈ [0, T ], (8.26)
∂x
and the function f (t, x, y) satisfies the equation
∂f ∂f
(t, St , M0t )dt + rSt f (t, St , M0t )dt
∂t ∂x
1 2 2 ∂2f ∂f
+ σ St 2 (t, St , M0t )dt + (t, St , M0t )dM0t = rf (t, St , M0t )dt,
2 ∂x ∂y
which implies
∂f ∂f 1 ∂2f
(t, St , M0t ) + rSt (t, St , M0t ) + σ 2 St2 2 (t, St , M0t ) = rf (t, St , M0t ),
∂t ∂x 2 ∂x
which is (8.22), and
∂f
(t, St , M0t )dM0t = 0,
∂y
because M0t increases only on a set of zero measure (which has no isolated
points). This implies
∂f
(t, St , St ) = 0,
∂y
which shows the boundary condition (8.23b), since M0t hits St when M0t
increases. On the other hand, (8.26) shows that
wT ∂f
φ(ST , M0T ) = IE∗ [φ(ST , M0T )] + σ St (t, x, M0t )|x=St dBt ,
0 ∂x
0 ≤ t ≤ T , which implies (8.24) as in the proof of Proposition 5.2.
In other words, the price of the lookback put option takes the form
" #
f (t, St , Mt ) = e−r(T −t) IE∗ M0T − ST Ft ,
where the function f (t, x, y) is given by
" 189

N. Privault
σ2

T −t T −t
f (t, x, y) = ye−r(T −t) Φ −δ−

(x/y) + x 1 + Φ δ+ (x/y)
2r
σ2 2r/σ 2 T −t
−x e−r(T −t) (y/x)

Φ −δ− (y/x) − x.
2r
The boundary condition (8.23a) is explained by the fact that
f (t, 0, y) = e−r(T −t) IE∗ [M0T − ST | St = 0, M0t = x]

= e−r(T −t) IE∗ [M0t − ST | St = 0, M0t = x]
= e−r(T −t) IE∗ [M0t | M0t = x] − e−r(T −t) IE∗ [ST | St = 0]
= xe−r(T −t) ,
since IE∗ [ST | St = 0] = 0 as St = 0 implies ST = 0. On the other hand,

(8.23c) follows from the fact that
f (T, x, y) = IE∗ [M0T − ST | ST = x, M0T = y] = y − x.
Note that we have

f (t, x, x) = xC(T − t),
with
σ2 σ 2 −rτ

C(τ ) = e−rτ Φ −δ−
τ τ τ

(1) + 1 + Φ δ+ (1) − e Φ −δ− (1) − 1,
2r 2r
τ > 0, hence
∂f
(t, x, x) = C(T − t), t ∈ [0, T ],
∂x
while we also have
∂f
(t, x, y)y=x = 0, 0 ≤ x ≤ y.
∂y
Scaling Property of Lookback Put Prices
We note the scaling property
190 "

" #
f (t, x, y) = e−r(T −t) IE∗ M0T − ST St = x, Mt = y
" #
−r(T −t) ∗
=e IE M0t ∨ MtT − ST St = x, Mt = y
" #
M0t MtT
= e−r(T −t) x IE∗ ∨ −1 St = x, Mt = y
St St
" #
y MtT
= e−r(T −t) x IE∗ ∨ −1 St = x, Mt = y
x St
" #
y
= e−r(T −t) x IE∗ M0t ∨ MtT − 1 St = 1, Mt =
x
= xf (t, 1, y/x)
= xg(T − t, x/y),
where we let
σ2

1 −rτ τ
τ

g(τ, z) := e Φ −δ− (z) + 1 + Φ δ+ (z)
z 2r
2r/σ2
σ2 1
− e−rτ τ
Φ(−δ− (1/z)) − 1,
2r z
with the boundary condition
∂g


 (τ, 1) = 0, τ > 0, (8.27a)
 ∂z



g(0, z) = 1 − 1,


z ∈ (0, 1]. (8.27b)

z
The next Figure 8.15 shows a graph of the function g(τ, z).
" 191

N. Privault
normalized lookback put price
1.2
1
0.8
0.6
0.4
0.2
0 1
0.6 0.8
0.7 0.6
z 0.8 0.4 τ
0.9 0.2
1 0
Fig. 8.15: Graph of the normalized lookback put option price.
Black-Scholes Approximation of Lookback Put Prices
Letting

S S
BSp (S, K, r, σ, τ ) = Ke−rτ Φ −δ−
τ τ
− SΦ −δ+
K K
denote the standard Black-Scholes formula for the price of a European put
option, we observe that the lookback put option price satisfies
e−r(T −t) IE∗ [M0T − ST | Ft ] = BSp (St , M0t , r, σ, T − t)

t 2r/σ2 t !
σ2

T −t St −r(T −t) M0 T −t M0
+St Φ δ+ −e Φ −δ− ,
2r M0t St St
i.e.
" #
St
e−r(T −t) IE∗ M0T − ST Ft = BSp (St , M0t , r, σ, T − t) + St hp T − t, t
M0
where the function

σ2 2
τ
(z) − e−rτ z −2r/σ Φ −δ−
τ

hp (τ, z) = Φ δ+ (1/z) , (8.28)
2r
depends only on time τ and z = St /M0t . In other words, due to the relation

x x
BSp (x, y, r, σ, τ ) = ye−rτ Φ −δ− τ τ
− xΦ −δ+
y y
= xBSp (1, y/x, r, σ, τ )
192 "

for the standard Black-Scholes put formula, we observe that f (t, x, y) satisfies
f (t, x, y) = xBSp (1, y/x, r, σ, T − t) + xh(T − t, x/y),
i.e.
f (t, x, y) = xg(T − t, x/y),
with
g(τ, z) = BSp (1, 1/z, r, σ, τ ) + hp (τ, z), (8.29)
where hp (τ, z) is the function given by (8.28), and (x, y) 7→ xhp (T − t, x/y)
also satisfies the Black-Scholes PDE (8.22), i.e. (τ, z) 7→ BSp (1, 1/z, r, σ, τ )
and hp (τ, z) both satisfy the PDE
∂hp ∂hp 1 ∂ 2 hp
(τ, z) = z r + σ 2 (τ, z) + σ 2 z 2 (τ, z), (8.30)
∂τ ∂z 2 ∂z 2
τ ∈ R+ , z ∈ [0, 1], under the boundary condition
hp (0, z) = 0, 0 ≤ z ≤ 1.
The next Figures 8.16 and 8.17 show the decompositions (8.29) of the normal-
ized lookback put option price g(τ, z) in Figure 8.15 into the Black-Scholes
put function BSp (1, 1/z, r, σ, τ ) and hp (τ, z).
normalized Black-Scholes put price BSp(1,1/z,r,σ,τ)
1.2
1
0.8
0.6
0.4
0.2
0 1
0.6 0.8
0.7 0.6
z 0.8 0.4 τ
0.9 0.2
1 0
Fig. 8.16: Black-Scholes put price in the decomposition (8.29).
" 193

N. Privault
h(τ,x)
1.2
1
0.8
0.6
0.4
0.2
0 1
0.6 0.8
0.7 0.6
z 0.8 0.4 τ
0.9 0.2
1 0
Fig. 8.17: Function hp (τ, z) in the decomposition (8.29).
Note that in Figures 8.16-8.17 the condition hp (0, z) = 0 is not fully respected
as z → 1 due to numerical error in the approximation of the function Φ.
The Lookback Call Option
The standard Lookback call option gives the right to buy the underlying asset
at its historically lowest price. In this case the strike is mT0 and the payoff is
C = ST − mT0 .
The following result gives the price of the lookback call option, cf. e.g. Propo-
sition 9.5.1, page 270 of [15].
Proposition 8.6. The price at time t ∈ [0, T ] of the lookback call option
with payoff ST − mT0 is given by
e−r(T −t) IE∗ [ST − mT0 | Ft ]

T −t St t −r(T −t) T −t St
= St Φ δ+ − m 0 e Φ δ−
mt0 mt0
2
t 2r/σ2 t
σ2

σ m0 T −t m0 T −t St
+e−r(T −t) St Φ δ− − St Φ −δ+ .
2r St St 2r mt0
Figure 8.18 represents the price of the lookback call option as a function of
mt0 and St for different values of the time to maturity T − t.
194 "

Lookback call option price
90
80
70
60
50
40
30
20 80
10 60
0
80 40 St
60
40 20
mt 20
0 0
Fig. 8.18: Graph of the lookback call option price.
Proof of Proposition 8.6. We have
e−r(T −t) IE∗ [ST − mT0 | Ft ] = e−r(T −t) IE∗ [ST | Ft ] − e−r(T −t) IE∗ [mT0 | Ft ],
and
IE∗ [mT0 | Ft ] = IE∗ [mt0 ∧ mTt | Ft ]

= IE∗ [mt0 1{mt0 <mTt } | Ft ] + IE∗ [mTt 1{mt0 >mTt } | Ft ]
= mt0 IE∗ [1{mt0 <mTt } | Ft ] + IE∗ [mTt 1{mt0 >mTt } | Ft ]
= mt0 P(mt0 < mTt | Ft ) + IE∗ [mTt 1{mt0 >mTt } | Ft ].
By computations similar to those of the lookback put option case we find

!
mt0 mT
P(mt0 < mTt | Ft ) = P < t Ft
St St
!
mTt
=P x< Ft
St
x=mt0 /St
!
T −t
m0
=P >x
S0 t x=m0 /St
t −1+2r/σ2 t
T −t St m0 T −t m0
= Φ δ− − Φ δ − ,
mt0 St St
and
" 195

N. Privault

Sr
IE∗ [mTt 1{mt0 >mTt } | Ft ] = St IE∗ min 1{mt0 /St >mTt /St }
r∈[t,T ] St x=mt0 ,y=St

Sr
= St IE∗ min 1{minr∈[t,T ] Sr /St <x}
r∈[t,T ] St x=mt0 /St

Sr
= St IE∗ min 1{minr∈[0,T −t] Sr /S0 <x}
r∈[0,T −t] S0 x=mt0 /St

T −t St µσ T −t St
= 2St er(T −t) Φ −δ+ t − St er(T −t) Φ −δ+ t
m0 r m0
2r/σ2
µσ mt0
t
T −t m 0
+St Φ δ− .
r St St
Given the relation µσ/r = 1 − σ 2 /(2r), this yields

!
mT0 −t
e−r(T −t) IE∗ [ST − mT0 | Ft ] = St − mt0 e−r(T −t) P >x
S0
x=mt0 /St

Sr
−St e−r(T −t) IE∗ min 1{minr∈[0,T −t] Sr /S0 <x}
r∈[0,T −t] S0 x=mt0 /St
t −1+2r/σ2 t
T −t St m0 T −t m0
= St − mt0 e−r(T −t) Φ δ− t + mt0 e−r(T −t) Φ δ−
m0 St St

T −t St µσ T −t St
−2St Φ −δ+ + St Φ −δ+
mt0 r mt0
t 2r/σ2 t
µσ m0 T −t m0
−St e−r(T −t) Φ δ−
r St St
σ2

t −r(T −t) T −t St T −t St
= St − m0 e Φ δ− t − St 1 + Φ −δ+ t
m0 2r m0
2
t 2r/σ2 t
σ m0 T −t m0
+St e−r(T −t) Φ δ−
2r St St

T −t St T −t St
= St Φ δ+ t − e−r(T −t) mt0 Φ δ− t
m0 m0
2
t 2r/σ2 t !
S
−r(T −t) t σ m 0 T −t m 0 r(T −t) T −t St
+e Φ δ− −e Φ −δ+ .
2r St St mt0
Black-Scholes Approximation of Lookback Call Prices
Letting
196 "


S S
τ
BSc (S, K, r, σ, τ ) = SΦ δ+ − Ke−rτ Φ δ−
τ
K K
denote the standard Black-Scholes formula for the price of a European call
option, we observe that the lookback call option price satisfies
e−r(T −t) IE∗ [ST − mT0 | Ft ] = BSc (St , mt0 , r, σ, T − t)

t 2r/σ2 t !
σ2

T −t St −r(T −t) m0 T −t m0
−St Φ −δ+ − e Φ δ − ,
2r mt0 St St
i.e.

St
e−r(T −t) IE∗ [ST − mT0 | Ft ] = BSc (St , mt0 , r, σ, T − t) + St hc T − t, t
m0
where the function

σ2 2
τ
(z) − e−rτ z −2r/σ Φ δ−
τ

hc (τ, z) = − Φ −δ+ (1/z) , (8.31)
2r
depends only on z = St /mt0 and satisfies
σ2 2

hc (τ, z) = hp (τ, z) − 1 − e−rτ z −2r/σ , τ ∈ R+ , z ∈ R+ ,
2r
2
where (z, τ ) 7→ e−rτ z −2r/σ also solves the PDE (8.30).
Black-Scholes PDE for Lookback Call Options
By the same argument as in the proof of Proposition 8.5, the function

f (t, x, y) satisfies the Black-Scholes PDE
∂f ∂f 1 ∂2f
rf (t, x, y) = (t, x, y) + rx (t, x, y) + x2 σ 2 2 (t, x, y), t, x > 0,
∂t ∂x 2 ∂x
under the boundary conditions

 lim f (t, x, y) = x, 0 ≤ t ≤ T, x > 0, (8.32a)
 y&0








∂f
(t, x, y)x=y = 0, 0 ≤ t ≤ T, y > 0, (8.32b)


 ∂y






f (T, x, y) = x − y, 0 ≤ y ≤ x, (8.32c)

" 197

N. Privault
and the corresponding self-financing hedging strategy is given by

∂f
ξt = (t, St , mt0 ), t ∈ [0, T ], (8.33)
∂x
which represents the quantity of the risky asset St to be held at time t in the
hedging portfolio.
In other words, the price of the lookback call option takes the form
f (t, St , mt ) = e−r(T −t) IE∗ [ST − mT0 | Ft ],

T −t x T −t x
f (t, x, y) = xΦ δ+ − e−r(T −t) yΦ δ− (8.34)
y y
2
σ 2 y 2r/σ T −t y

T −t x
+e−r(T −t) x Φ δ− − er(T −t) Φ −δ+
2r x x y
2

T −t x σ T −t x
= x − ye−r(T −t) Φ δ− −x 1+ Φ −δ+
y 2r y
2 2r/σ 2
−r(T −t) σ y T −t y

+xe Φ δ− .
2r x x
The boundary condition (8.32a) is explained by the fact that
f (t, x, 0) = e−r(T −t) IE∗ [ST − mT0 | St = x, mt0 = 0]

= e−r(T −t) IE∗ [ST | St = x, mt0 = 0]
= e−r(T −t) IE∗ [ST | St = x]
= e−r(T −t) x.
On the other hand, (8.32b) follows from the fact that
f (T, x, y) = IE∗ [ST − mT0 | ST = x, mT0 = y] = x − y.
We have
f (t, x, x) = xC(T − t),
with
198 "

σ2 σ2

C(τ ) = 1 − e−rτ Φ δ−
τ τ
(1) + e−rτ Φ δ−
τ

(1) − 1 + Φ −δ+ (1) ,
2r 2r
τ > 0, hence
∂f
(t, x, x) = C(T − t), t ∈ [0, T ],
∂x
while we also have
∂f
(t, x, y)y=x = 0, 0 ≤ x ≤ y.
∂y
Scaling Property of Lookback Call Prices
We note the scaling property

" #
f (t, x, y) = e−r(T −t) IE∗ ST − mT0 St = x, mt = y
" #
= e−r(T −t) IE∗ mt0 ∧ mTt − ST St = x, mt = y
" #
−r(T −t) ∗ mt0 mTt
=e x IE ∨ −1 St = x, mt = y
St St
" #
y mTt
= e−r(T −t) x IE∗ ∨ −1 St = x, mt = y
x St
" #
= e−r(T −t) x IE∗ mt0 ∨ mTt − 1 St = 1, mt = y/x
= xf (t, 1, y/x),
hence letting
σ2

1
g(τ, z) = 1 − e−rτ Φ δ−τ τ

(z) − 1 + Φ −δ+ (z)
z 2r
σ2 2
+ e−rτ z −2r/σ Φ(δ− τ
(1/z)),
2r
we have g(τ, 1) = C(T − t), and
f (t, x, y) = xg(T − t, x/y)
and the boundary condition
" 199

N. Privault
∂g

 (τ, 1) = 0, τ > 0, (8.35a)


 ∂z


g(0, z) = 1 − 1 ,


z ≥ 1. (8.35b)

z
The next Figure 8.19 shows a graph of the function g(τ, z).
normalized lookback call price

option price path
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1 0
50
03 100
2.5 150 t
2
z 1.5 200
1
Fig. 8.19: Normalized lookback call option price.
The next Figure 8.20 represents the path of the underlying asset price used
in Figure 8.19.
Fig. 8.20: Graph of the underlying asset price.
200 "

Next we represent the option price as a function of time.
option price path

60 St-mt
50
40
30
20
10
0
0 50 100 150 200
t
Fig. 8.21: Graph of the lookback call option price.
The next Figure 8.22 represents the corresponding underlying asset price and
its running minimum.
100
St
mt
90
80
70
60
50
40
30
20
0 50 100 150 200
t
Fig. 8.22: Running minimum of the underlying asset price.
Due to the relation

x x
BSc (x, y, r, σ, τ ) = xΦ δ+ τ
− ye−rτ Φ δ−
τ
y y
= xBSc (1, y/x, r, σ, τ )
for the standard Black-Scholes call formula, we observe that f (t, x, y) satisfies
" 201

N. Privault
f (t, x, y) = xBSc (1, y/x, r, σ, T − t) + xhc (T − t, x/y),
i.e.
f (t, x, y) = xg(T − t, x/y),
with
g(τ, z) = BSc (1, 1/z, r, σ, τ ) + hc (τ, z), (8.36)
where hc (τ, z) is the function given by (8.31), and (x, y) 7→ xhc (T − t, x/y)
also satisfies the Black-Scholes PDE (8.22), i.e. (τ, z) 7→ BSc (1, 1/z, r, σ, τ )
and hc (τ, z) both satisfy the PDE (8.30) under the boundary condition
hc (0, z) = 0, z ≥ 1.
The next Figures 8.23 and 8.24 show the decomposition of g(t, z) in (8.36) and
Figures 8.19-8.20 into the sum of the Black-Scholes call function BSc (1, 1/z, r, σ, τ )
and h(t, z).
normalized Black-Scholes put price BSc(1,1/z,r,σ,T-t)
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1 0
50
03 100
2.5 150 t
2
z 1.5 200
1
Fig. 8.23: Black-Scholes call price in the decomposition (8.36) of the normalized
lookback call option price g(τ, z).
202 "

h(T-t,x)
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1 0
50
03 100
2.5 150 t
2
z 1.5 200
1
Fig. 8.24: Function hc (τ, z) in the decomposition (8.36) of the normalized lookback
call option price g(τ, z).
We also note that
IE∗ [M0T − mT0 | S0 = x] = x − xe−r(T −t) Φ δ− T −t

(1)
σ2 σ2

T −t T −t
(1) + xe−r(T −t) Φ δ−

−x 1 + Φ −δ+ (1)
2r 2r
σ2

T −t T −t
+xe−r(T −t) Φ −δ−

(1) + x 1 + Φ δ+ (1)
2r
σ2 T −t
−x e−r(T −t) Φ −δ−

(1) − x
2r
σ2

T −t T −t

= x 1+ Φ δ+ (1) − Φ −δ+ (1)
2r
2
σ T −t T −t
+xe−r(T −t)

− 1 Φ δ− (1) − Φ −δ− (1) .
2r
Hedging of Lookback Options
In this section we compute hedging strategies for lookback options by ap-

plication of the Delta hedging formula (8.33). See [3], § 2.6.1, page 29, for
another approach to the following result using the Clark-Ocone formula.
Here we use (8.33) instead, cf. Proposition 4.6 of [45].
Proposition 8.7. The hedging strategy of the lookback call option is given
by
σ2

T −t St T −t St
ξt = Φ δ + − Φ −δ + (8.37)
mt0 2r mt0
" 203

N. Privault
2r/σ2
mt0 σ2
t
T −t m0
+e−r(T −t) − 1 Φ δ− , t ∈ [0, T ].
St 2r St
Proof. We need to differentiate

x
f (t, x, y) = BSc (x, y, r, σ, T − t) + xhc T − t,
y
with respect to the variable x, where
σ2 2
τ
(z) − e−rτ z −2r/σ Φ δ−
τ

hc (τ, z) = − Φ −δ+ (1/z)
2r
is given by (8.31) First we note that the relation

∂ τ x
BSc (x, y, r, σ, τ ) = Φ δ+
∂x y
is known, cf. Propositions 5.4 and 6.7. Next, we have

∂ x x x ∂hc x
xhc τ, = hc τ, + τ, ,
∂x y y y ∂z y
and
σ2

∂hc ∂ 2 ∂
τ
(z) − e−rτ z −2r/σ τ

(τ, z) = − Φ −δ+ Φ(δ− (1/z))
∂z 2r ∂x ∂z
σ 2 2r −rτ −1−2r/σ2

τ
− e z Φ(δ − (1/z))
2r σ 2

σ 1 τ 2
= √ exp − δ+ (z)
2rz 2πτ 2

−rτ −2r/σ 2 σ 1 τ 2
−e z √ exp − (δ− (1/z))
2rz 2πτ 2

2r 2
+ 2 e−rτ z −1−2r/σ Φ(δ− τ
(1/z)) .
σ
Next we note that

2 1 4r2 √

τ 2 1 τ 4r τ
e−(δ− (1/z)) /2
= exp − δ+ (z) − 2
τ − δ+ (z) τ
2 2 σ σ
1 4r2

− 12 (δ+
τ
(z))
2 4r 1 2
=e exp − τ − log z + (r + σ )τ
2 σ2 σ2 2
2 2
−2r

2 2r 2r
= e− 2 (δ+ (z)) exp
1 τ
τ + 2 log z + 2 τ + rτ
σ2 σ σ
2 τ 2
= erτ z 2r/σ e−(δ+ (z)) /2
(8.38)
204 "

as in the proof of Proposition 5.4, hence

∂hc x 2
τ, = −e−rτ z −1−2r/σ Φ(δ−
τ
(1/z)),
∂z y
and
∂

x

x
y 2r/σ2 y
xhc τ, = hc τ, − e−rτ τ
Φ δ− ,
∂x y y x x
which concludes the proof.

Similar calculations using (8.24) can be carried out for other types of look-
back options, such as options on extrema and partial lookback options, cf.
[44].
As a consequence of (8.37) we have
e IE∗ [ST − mT0 | Ft ]

−r(T −t)

T −t St t −r(T −t) T −t St
= St Φ δ+ − m 0 e Φ δ −
mt0 mt0
2
−2r/σ2 t
σ2

σ St T −t m0 T −t St
+e−r(T −t) St Φ δ − − St Φ −δ+
2r mt0 St 2r mt0
1−2r/σ2 t !
T −t St St T −t m0
= ξt St − mt0 e−r(T −t) Φ δ− + Φ δ− ,
mt0 mt0 St
and the quantity of the riskless asset ert in the portfolio is given by
1−2r/σ2 t !
T −t St St T −t m0
ηt = −mt0 e−rT Φ δ− + Φ δ −
mt0 mt0 St
≤ 0,
so that the portfolio value Vt at time t satisfies
Vt = ξt St + ηt ert , t ∈ R+ ,
and one has to constantly borrow from the riskless account in order to hedge
the lookback option.
8.5 Asian Options
As we will see below there exists no easily tractable closed form solution for
the price of an arithmetically averaged Asian option.
" 205

N. Privault
General Results
An option on average is an option whose payoff has the form
C = φ(YT , ST ),
where wT wT
2
YT = S0 eσBu +ru−σ u/2
du = Su du, T ∈ R+ .
0 0
+
• For example when φ(y, x) = (y/T − K) this yields the Asian call option
with payoff
w + +
1 T YT
Su du − K = −K , (8.39)
T 0 T
which is a path-dependent option whose price at time t ∈ [0, T ] is given
by
1 wT
" + #
−r(T −t) ∗
e IE Su du − K Ft . (8.40)
T 0
• As another example, when φ(y, x) = e−y this yields the price

h rT i
P (0, T ) = IE∗ e− 0 Su du = IE∗ e−YT

at time 0 of a bond with underlying short term rate process St .

The option with payoff C = φ(YT , ST ) can be priced as
wT
" #
e−r(T −t) IE∗ [φ(YT , ST ) | Ft ] = e−r(T −t) IE∗ φ Yt + Su du, ST Ft
t
wT S
" #
−r(T −t) ∗ u ST
=e IE φ y + x du, x Ft
t St St
y=Yt ,x=St
w T −t S ST −t

−r(T −t) ∗ u
=e IE φ y + x du, x . (8.41)
0 S0 S0 y=Yt ,x=St
Hence the option can be priced as
f (t, St , Yt ) = e−r(T −t) IE∗ [φ(YT , ST ) | Ft ],

w T −t S ST −t

u
f (t, x, y) = e−r(T −t) IE∗ φ y + x du, x .
0 S0 S0
First we note that the numerical computation of Asian option prices can
be done using the joint probability density ψYT −t ,BT −t of (YT −t , BT −t ), as
206 "

follows:
f (t, x, y) =
w∞w∞ 2

e−r(T −t) φ y + xz, xeσu+r(T −t)−σ (T −t)/2 ψYT −t ,BT −t (z, u)dzdu.
0 −∞
In [79], Proposition 2, the joint probability density of

w
t 2
(Yt , Bt ) = S0 eσBs −pσ s/2 ds, Bt − pσt/2 , t > 0,
0
has been computed in the case σ = 2, cf. also [52]. In the next proposition
we restate this result for an arbitrary variance parameter σ after rescaling.
Let θ(v, τ ) denote the function defined as
veπ /(2τ ) w ∞ −ξ2 /(2τ ) −v cosh ξ

2
θ(v, τ ) = √ e e sinh(ξ) sin (πξ/τ ) dξ, v, τ > 0.

2π 3 τ 0
(8.42)
Proposition 8.8. For all t > 0 we have
w
t 2
P eσBs −pσ s/2 ds ∈ dz, Bt − pσt/2 ∈ du
0
1 + eσu
σu/2 2
σ −pσu/2−p2 σ2 t/8 4e σ t dz
= e exp −2 2
θ , du,
2 σ z σ2 z 4 z
u ∈ R, z > 0.
The expression of this probability density can then been used for the pricing
of options on average such as (8.41), as
w T −t S ST −t

v
f (t, x, y) = e−r(T −t) IE∗ φ y + x dv, x
0 S0 S0
= e−r(T −t)
w∞ 2
w T −t S
v
× φ y + xz, xeσu+r(T −t)−σ (T −t)/2 P dv ∈ dz, BT −t ∈ du
0 0 S0
σ 2 2
w∞w∞ 2

= e−r(T −t)+p σ (T −t)/8 φ y + xz, xeσu+r(T −t)−σ (1+p)(T −t)/2
2 0 −∞
! !
2 2
1 + eσu−pσ (T −t)/2 p 4eσu/2−pσ (T −t)/4 σ 2 (T − t) dz
× exp −2 − σu θ , du
σ2 z 2 σ2 z 4 z
w∞w∞
−r(T −t)−p2 σ 2 (T −t)/8 2 r(T −t)−σ 2 (T −t)/2
=e φ y + x/z, xv e
0
2
0
4vz σ 2 (T − t)

1+v dz
×v −1−p exp −2z θ , dv ,
σ2 σ2 4 z
" 207

N. Privault
which actually stands as a triple integral due to the definition (8.42) of θ(v, τ ).
Note that here the order of integration between du and dz cannot be ex-
changed without particular precautions, at the risk of wrong computations.
The Asian Call Option
We have
1 wT
" + #
e−r(T −t) IE∗ Su du − K Ft
T 0
wT
" + #
1
= e−r(T −t) IE∗ Yt + Su du − K Ft
T t
wT S
" + #
−r(T −t) ∗ 1 u
=e IE y+x du − K Ft
T t St
x=St , y=Yt
w T −t S
" + #
1 u
= e−r(T −t) IE∗ y+x du − K .
T 0 S0
x=St , y=Yt
Hence the option can be priced as
1 wT
" + #
f (t, St , Yt ) = e−r(T −t) IE∗ Su du − K Ft ,
T 0
where the function f (t, x, y) is defined by
w T −t S
" + #
1 u
f (t, x, y) = e−r(T −t) IE∗ y+x du − K
T 0 S0
" + #
1 x
= e−r(T −t) IE∗ y+ YT −t − K .
T S0
Probabilistic Approach
First we note that the numerical computation of Asian option prices can be
done using the probability density of
wT
YT = St dt.
0
From Proposition 8.8 we deduce the marginal density of
208 "

wt 2
Yt = eσBs −pσ s/2
ds,
0
as follows:
w
t 2
P eσBs −pσ s/2 ds ∈ du
0
σ p2 σ2 t/8 w ∞
2
! 2
!
1 + eσv−pσ t/2 p 4eσv/2−pσ t/4 σ 2 t
= e exp −2 − σv θ , dvdu
2u −∞ σ2 u 2 σ2 u 4
2 2
w∞
1 + v2

4v σ 2 t

du
= e−p σ t/8 v −1−p exp −2 2 θ , dv ,
0 σ u σ2 u 4 u
u > 0. From this we get

w
t
P(Yt /S0 ∈ du) = P St dt ∈ du (8.43)
0
2 2
w ∞

1+v 2
2
4v σ t

du
= e−p σ t/8 v −1−p exp −2 2 θ , dv ,
0 σ u σ2 u 4 u
2
where St = S0 eσBt −pσ t/2 and p = 1 − 2r/σ 2 . This probability density can
then be used for the pricing of Asian options, as
" + #
1 x
f (t, x, y) = e−r(T −t) IE∗ y+ YT −t − K (8.44)
T S0
w ∞ y + xz +
= e−r(T −t) −K P(YT −t /S0 ∈ dz)
0 T
σ 2 2
w ∞ ∞w
y + xz
+
= e−r(T −t) e−p σ (T −t)/8 −K
2 0 0 T
1 + v2 4v σ 2 (T − t)

−1−p dz
×v exp −2 2 θ , dv
σ z σ2 z 4 z
1 −r(T −t)−p2 σ2 (T −t)/8 w ∞ w∞
= e (xz + y − KT )
T 0∨(KT −y)/x 0
2 2
4v σ (T − t)

1+v dz
× exp −2 2 θ , dv
σ z σ2 z 4 z
4x −r(T −t)−p2 σ2 (T −t)/8 w ∞ w ∞ 1 σ 2 (KT − y)
+
= 2 e −
σ T 0 0 z 4x
1 + v2 σ 2 (T − t)

−1−p dz
×v exp −z θ vz, dv ,
2 4 z
cf. the Theorem in § 5 of [9], which is actually a triple integral due to the
definition (8.42) of θ(v, t). Note that since the integrals are not absolutely
convergent, here the order of integration between dv and dz cannot be ex-
" 209

N. Privault
changed without particular precautions, at the risk of wrong computations.
The time Laplace transform of Asian option prices has been computed in
[29], and this expression can be used for pricing by numerical inversion of the
Laplace transform. The following Figure 8.25 represents Asian option prices
computed by the Geman-Yor [29] method.
Asian option price
30
25
20
15
10
100
95
underlying 90
85 350
250 300
150 200
80 0 50 100
Time in days
Fig. 8.25: Graph of the Asian option price with σ = 0.3, r = 0.1 and K = 90.
We refer to e.g. [2], [9], [20], and references therein for more on Asian op-
tion pricing using the probability density of the averaged geometric Brownian
motion.
Figure 7.1 presents a graph of implied volatility surface for Asian options on
light sweet crude oil futures.
Lognormal approximation
Other numerical approaches to the pricing of Asian options include [49], [73]
which relies on approximations of the average price probability based on
the Lognormal distribution. The lognormal distribution with mean µ and
variance η 2 has the probability density function
1 2 2 dx
g(x) = √ e−(µ−log x) /(2η ) ,
η 2π x
where x > 0, µ ∈ R, η > 0, and moments

2 2
E[X] = eµ+η /2
and E[X 2 ] = e2µ+2η . (8.45)
Under the lognormal approximation, asian options on the time integral

wT
ΛT := St dt
0
210 "

of geometric Brownian motion

2
St = eσBt +(r−σ /2)t
, t ∈ [0, T ],
are computed by approximating ΛT by a lognormal random variable, as
1 wT
" + #
1 2
e−rT E St dt − K ' eµ̂+σ̂ /2 Φ(d1 ) − KΦ(d2 ), (8.46)
T 0 T
where
√
log(E[ΛT ]/(KT )) T µ̂T + σ̂ 2 T − log(KT )
d1 = √ + σ̂ = √
σ̂ T 2 σ̂ T
and √
√ log(E[ΛT ]/(KT )) T
d2 = d1 − σ̂ T = √ − σ̂ ,
σ̂ T 2
and µ̂, σ̂ are estimated as
E[Λ2T ]

1
σ̂ 2 = log
T (E[ΛT ])2
and
1 1
log E[ΛT ] − σ̂ 2 , µ̂ =
T 2
based on the first two moments of the lognormal distribution, cf. (8.45) below.
The next Figure 8.26 compares the lognormal approximation to a Monte
Carlo estimate of Asian option prices with σ = 0.5, r = 0.05 and K/St = 1.1
0.24
lognormal approximation
Monte Carlo estimate
0.22
0.2
0.18
asian option price
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0 1 2 3 4 5 6 7 8 9 10
time t
Fig. 8.26: Lognormal approximation to the Asian option price.
" 211

N. Privault
For reference, in the next proposition we compute the unconditional mean

and variance of ΛT , which have been used in (8.46), cf. also (7) and (8) page
480 of [49].
Proposition 8.9. We have
erT − 1
E[ΛT ] = S0 ,
r
and 2
re(2r+σ )T
− (2r + σ 2 )erT + (r + σ 2 )
E[(ΛT )2 ] = 2S02 .
r(r + σ 2 )(2r + σ 2 )
Proof. The computation of the first moment is straightforward. For the
second moment we have, letting p = 1 − 2r/σ 2 ,
wT wT 2 2
E[(ΛT )2 ] = S02 e−pσ a/2−pσ b/2 E[eσBa eσBb ]dbda
0 0
wT wa 2 2 2 2
= 2S02 e−pσ a/2−pσ b/2 eσ (a+b)/2 ebσ dbda
0 0
wT 2
w a 2
= 2S02 e−(p−1)σ a/2 e−(p−3)σ b/2 dbda
0 0
4S02 wT 2 2
= e−(p−1)σ a/2 (1 − e−(p−3)σ a/2 )da
(p − 3)σ 02
4S02 wT 2 4S02 wT 2 2
= e−(p−1)σ a/2 da − e−(p−1)σ a/2 e−(p−3)σ a/2 da
(p − 3)σ 2 0 (p − 3)σ 2 0
8S02 2 4S02 wT 2
= (1 − e−(p−1)σ T /2 ) − e−(2p−4)σ a/2 da
(p − 3)(p − 1)σ 4 (p − 3)σ 0
2
8S02 2 4S02 2
= (1 − e−(p−1)σ T /2 ) − (1 − e−(p−2)σ T )
(p − 3)(p − 1)σ 4 (p − 3)(p − 2)σ 4
2
re(2r+σ )T
− (2r + σ 2 )erT + (r + σ 2 )
= 2S02 ,
r(r + σ 2 )(2r + σ 2 )
since r − σ 2 /2 = −pσ 2 /2.
PDE Method - Two Variables
The price at time t of the Asian option with payoff (8.39) can be written as
1 wT
" + #
f (t, St , Yt ) = e−r(T −t) IE∗ Su du − K Ft , t ∈ [0, T ].
T 0
(8.47)
Next, we derive the Black-Scholes partial differential equation (PDE) for the
price of a self-financing portfolio. Until the end of this chapter we model the
212 "

asset price (St )t∈[0,T ] as
dSt = µSt dt + σSt dWt , t ∈ R+ ,
where (Wt )t∈R+ is a standard Brownian motion under the historical proba-
bility measure P.
Vt = f (t, Yt , St ), t ∈ R+ ,
for some f ∈ C 2 ((0, ∞) × (0, ∞)2 ).

Then the function f (t, x, y) in (8.47) satisfies the PDE
∂f ∂f ∂f 1 ∂2f
rf (t, x, y) = (t, x, y) + x (t, x, y) + rx (t, x, y) + x2 σ 2 2 (t, x, y),
∂t ∂y ∂x 2 ∂x
t, x > 0, under the boundary conditions
 y +
f (t, 0, y) = e−r(T −t)
 −K , 0 ≤ t ≤ T, y ∈ R+ , (8.48a)
T









lim f (t, x, y) = 0, 0 ≤ t ≤ T, x ∈ R+ , (8.48b)
 y→−∞







 y +
f (T, x, y) = −K , x, y ∈ R+ , (8.48c)


T
and ξt is given by
∂f
ξt =(t, St , Yt ), t ∈ R+ .
∂x
Proof. We note that the self-financing condition implies
dVt = ηt dAt + ξt dSt

= rηt At dt + µξt St dt + σξt St dWt (8.49)
= rVt dt + (µ − r)ξt St dt + σξt St dWt
= rηt At dt + µξt St dt + σξt St dWt , (8.50)
t ∈ R+ . Noting that dYt = St dt, the application of Itô’s formula to f (t, x, y)

leads to
" 213

N. Privault
∂f ∂f
df (t, St , Yt ) =
(t, St , Yt )dt + St (t, St , Yt )dt
∂t ∂y
∂f 1 2 2 ∂2f ∂f
+µSt (t, St , Yt )dt + St σ (t, St , Yt )dt + σSt (t, St , Yt )dWt .
∂x 2 ∂x2 ∂x
(8.51)
By respective identification of the terms in dWt and dt in (8.49) and (8.51)

we get
 ∂f ∂f ∂f
 rηt At dt + µξt St dt = (t, St , Yt )dt + St (t, St , Yt )dt + µSt (t, St , Yt )dt
∂t ∂y ∂x



1 2 2 ∂2f




 + St σ (t, St , Yt )dt,
2 ∂x2





 ξ S σdW = S σ ∂f (t, S , Y )dW ,



t t t t t t t
∂x
hence
2
 rVt − rξt St = ∂f (t, St , Yt ) + St ∂f (t, St , Yt )dt + 1 St2 σ 2 ∂ f (t, St , Yt ),


∂t ∂y 2 ∂x2


 ξt = ∂f (t, St , Yt ),



∂x
i.e.
 ∂f ∂f ∂f
 rf (t, St , Yt ) =
 (t, St , Yt ) + St (t, St , Yt ) + rSt (t, St , Yt )

 ∂t ∂y ∂x
∂2f

 1
+ St2 σ 2 2 (t, St , Yt ),



2 ∂x





 ξ = ∂f (t, S , Y ).



t t t
∂x

Next we examine two methods which allow one to reduce the Asian option
pricing PDE from two variables to one variable.
PDE Method - One Variable (1) - Time Independent Coefficients
Following [47], page 91, we define the auxiliary process
1 1 wt

1 Yt
Zt = Su du − K = −K , t ∈ [0, T ].
St T 0 St T
214 "

With this notation, the price of the Asian option at time t becomes
1 wT
" + # " #
−r(T −t) ∗ −r(T −t) ∗
e IE Su du − K Ft = e IE ST (ZT )+ Ft .
T 0
Lemma 8.1. The price (8.40) at time t of the Asian option with payoff
(8.39) can be written as
St g(t, Zt ), t ∈ [0, T ],
where
1 w T −t Su
" + #
g(t, z) = e−r(T −t) IE∗ z+ du (8.52)
T 0 S0
" + #
YT −t
= e−r(T −t) IE∗ z+ .
S0 T
Proof. For 0 ≤ s ≤ t ≤ T , we have
w
1 t St
d (St Zt ) = d Su du − K = dt,
T 0 T
hence
St Zt 1 w t Su
= Zs + du, t ≥ s.
Ss T s Ss
Since for any t ∈ [0, T ], St is positive and Ft -measurable, and Su /St is inde-
pendent of Ft , u ≥ t, we have:
" # " + #
ST
e−r(T −t) IE∗ ST (ZT )+ Ft = e−r(T −t) St IE∗ ZT Ft
St
w
" + #
−r(T −t) ∗ 1 T Su
=e St IE Zt + du Ft
T t St
1 w T Su
" #
+
= e−r(T −t) St IE∗ z+ du Ft
T t St
z=Zt
1 w T −t Su
" + #
−r(T −t) ∗
=e St IE z+ du
T 0 S0
z=Zt
" + #
−r(T −t) ∗ YT −t
=e St IE z+
S0 T
z=Zt
= St g(t, Zt ),
which proves (8.52).
" 215

N. Privault
Note that as in (8.44), g(t, z) can be computed from the density (8.43) of
YT −t , as
" + #
YT −t
g(t, z) = IE∗ z+
S0 T
w∞ u +
= z+ P(Yt /S0 ∈ du)
0 T
−p2 σ 2 t/8
=e
w∞ u + w ∞ −1−p

1 + v2

4v σ 2 (T − t)

du
× z+ v exp −2 2
θ 2
, dv
0 T 0 σ σ u 4 u
2 2
= e−p σ t/8
w∞ u w ∞ −1−p

1 + v2

4v σ 2 (T − t)

du
× z+ v exp −2 θ , dv
(−zT )∨0 T 0 σ2 σ2 u 4 u
2 2
w∞ w∞
1 + v 2

4v σ 2
(T − t)

du
= ze−p σ t/8 v −1−p exp −2 θ , dv
(−zT )∨0 0 σ2 σ2 u 4 u
1 −p2 σ2 t/8 w ∞ w∞ 1 + v2 4v σ 2 (T − t)

−1−p
+ e v exp −2 θ , dvdu.
T (−zT )∨0 0 σ2 σ2 u 4
The next proposition gives a replicating hedging strategy for Asian options.
Vt = St g(t, Zt ), t ∈ R+ ,
for some f ∈ C 2 ((0, ∞) × (0, ∞)2 ).

Then the function g(t, x) satisfies the PDE
∂2g

∂g 1 ∂g 1
(t, z) + − rz (t, z) + σ 2 z 2 2 (t, z) = 0, (8.53)
∂t T ∂z 2 ∂z
under the terminal condition
g(T, z) = z + ,
and the corresponding replicating portfolio is given by

∂g
ξt = g(t, Zt ) − Zt
g(t, Zt ), t ∈ [0, T ].
∂z
Proof. We proceed as in [66]. From the expression of 1/St we have
216 "


1 1
−µ + σ 2 dt − σdWt ,

d =
St St
hence

1 Yt
dZt = d −K
St T

Yt K
=d −
T St St

1 Yt 1
= d − Kd
T St St

1 dYt Yt 1
= + −K d
T St T St

dt 1
= + St Zt d
T St
dt
+ Zt −µ + σ 2 dt − Zt σdWt .

=
T
By self-financing we have
dVt = ηt dAt + ξt dSt

= rηt At dt + µξt St dt + σξt St dWt , (8.54)
t ∈ R+ . The application of Itô’s formula to f (t, x, y) leads to
d(St g(t, Zt )) = g(t, Zt )dSt + St dg(t, Zt ) + dSt · dg(t, Zt )

∂g ∂g
= (t, Zt )dt + (t, Zt )dZt
∂t ∂z
2
1∂ g
+ (t, Zt )(dZt )2 + dSt · dg(t, Zt )
2 ∂z 2
∂g
= St (t, Zt )dt + µSt g(t, Zt )dt + σSt g(t, Zt )dWt
∂t
∂g 1 ∂g ∂g
+St Zt −µ + σ 2 (t, Zt )dt + St (t, Zt )dt − σSt Zt (t, Zt )dWt
∂z T ∂z ∂z
1 2 2 ∂2g 2 ∂g
+ σ Zt St 2 (t, Zt )dt − σ St Zt (t, Zt )dt
2 ∂z ∂z
∂g ∂g 1 ∂g
= µSt g(t, Zt )dt + St (t, Zt )dt + St Zt −µ + σ 2 (t, Zt )dt + St (t, Zt )dt
∂t ∂z T ∂z
1 ∂2g ∂g
+ σ 2 Zt2 St 2 (t, Zt )dt − σ 2 St Zt (t, Zt )dt
2 ∂z ∂z
∂g
+σSt g(t, Zt )dWt − σSt Zt (t, Zt )dWt .
∂z
" 217

N. Privault

we get
∂g ∂g


 rηt At + µξt St = µSt g(t, Zt ) + St (t, Zt ) − µSt Zt (t, Zt )

 ∂t 2
∂z
1 ∂g 1 ∂ g


+ St (t, Zt ) + σ 2 Zt2 St 2 (t, Zt ),



T ∂z 2 ∂z





 ξ S σ = σS g(t, Z ) − σS Z ∂g (t, Z ),



t t t t t t t
∂z
hence
∂2g

∂g 1 ∂g 1
 rVt − rξt St = St (t, Zt ) + St (t, Zt ) + σ 2 Zt2 St 2 (t, Zt ),


 ∂t T ∂z 2 ∂z
 ξt = g(t, Zt ) − Zt ∂g (t, Zt ),



∂z
i.e.
∂2g

∂g 1 ∂g 1

 (t, z) +

 ∂t − rz (t, z) + σ 2 z 2 2 (t, z) = 0,
T ∂z 2 ∂z

 ξ = g(t, Z ) − Z ∂g (t, Z ),



t t t t
∂z
g(T, z) = z + .

We check that
∂f ∂f
ξt = e−r(T −t) σSt f (t, St , Zt ) − σZt f (t, St , Zt )
∂x ∂z

−r(T −t) ∂g
=e −Zt (t, Zt ) + g(t, Zt )
∂z
1 1 wt
!
−r(T −t) ∂g
=e St t, Su du − K + g(t, Zt )
∂x x T 0 |x=St
w
∂ 1 1 t
= xe−r(T −t) g t, Su du − K , t ∈ [0, T ].
∂x x T 0 |x=St
We also find that the amount invested on the riskless asset is given by
∂g
ηt At = Zt St (t, Zt ).
∂z
218 "

Next we note that a PDE with no first order derivative term can be obtained
using time-dependent coefficients.
PDE Method - One Variable (2) - Time Dependent Coefficients
Define now the auxiliary process
1 1 wt

1
Ut := (1 − e−r(T −t) ) + e−r(T −t) Su du − K
rT St T 0
1 −r(T −t) −r(T −t)
= (1 − e )+e Zt , t ∈ [0, T ],
rT
i.e.
er(T −t) − 1
Zt = er(T −t) Ut + , t ∈ [0, T ].
rT
We have
1
dUt = − e−r(T −t) dt + re−r(T −t) Zt dt + e−r(T −t) dZt
T
= e−r(T −t) σ 2 Zt dt − e−r(T −t) σZt dWt − (µ − r)e−r(T −t) Zt dt
= −e−r(T −t) σZt dŴt , t ∈ R+ ,
where
µ−r
dŴt = dWt − σdt + dt = dW̃t − σdt
σ
is a standard Brownian motion under
2 ST ∗
dP̂ = eσWT −σ t/2
dP∗ = e−rT dP .
S0
Lemma 8.2. The Asian option price can be written as
1 wT
" + #
St h(t, Ut ) = e−r(T −t) IE∗ Su du − K Ft ,
T 0
where the function h(t, y) is given by

" #
ˆ (UT )+ Ut = y ,
h(t, y) = IE 0 ≤ t ≤ T.
Proof. We have
1 wT

1
UT = Su du − K = ZT ,
ST T 0
and
" 219

N. Privault
dP̂|Ft 2 e−rT ST
= eσ(WT −Wt )−σ (T −t)/2 = −rt ,
dP∗|Ft e St
hence the price of the Asian option is
e−r(T −t) IE∗ [ST (ZT )+ | Ft ] = e−r(T −t) IE∗ [ST (UT )+ | Ft ]
" #
e−rT ST
= St IE∗ (U T ) +
F t
e−rt St
" #
∗ dP̂|Ft +
= St IE (UT ) Ft
dP∗|Ft
ˆ
= St IE[(U +
T ) | Ft ].

The next proposition gives a replicating hedging strategy for Asian options.
See § 7.5.3 of [71] and references therein for a different derivation of the
PDE (8.55).
Vt = St h(t, Ut ) t ∈ R+ ,
2 2
for some f ∈ C ((0, ∞) × (0, ∞) ).
Then the function h(t, z) satisfies the PDE
2
1 − e−r(T −t) ∂2h

∂h 1
(t, y) + σ 2 −y (t, y) = 0, (8.55)
∂t 2 rT ∂y 2
h(T, z) = z + ,
and the corresponding replicating portfolio is given by

∂h
ξt = h(t, Ut ) − Zt (t, Ut ), t ∈ [0, T ].
∂y
Proof. By the self-financing condition (8.50) we have
dVt = rVt dt + (µ − r)ξt St dt + σξt St dWt , (8.56)
t ∈ R+ . By Itô’s formula we get

220 "

d(St h(t, Ut )) = h(t, Ut )dSt + St dh(t, Ut ) + dSt · dh(t, Ut )

= µSt h(t, Ut )dt + σSt h(t, Ut )dWt
1 ∂2h

∂h ∂h
+St (t, Ut )dt + (t, Ut )dUt + 2
(t, Ut )(dUt )2
∂t ∂y 2 ∂y
∂h
+ (t, Ut )dSt · dUt
∂y
∂h
= µSt h(t, Ut )dt + σSt h(t, Ut )dWt − St (µ − r) (t, Ut )Zt dt
∂y
1 2 ∂2h

∂h ∂h
+St (t, Ut )dt − σ (t, Ut )Zt dW̃t + σ 2
(t, Ut )Zt2 dt
∂t ∂y 2 ∂y
2 ∂h
−σ St (t, Ut )Zt dt
∂y
∂h
= µSt h(t, Ut )dt + σSt h(t, Ut )dWt − St (µ − r) (t, Ut )Zt dt
∂y
1 ∂2h

∂h ∂h
+St (t, Ut )dt − σ (t, Ut )Zt (dWt − σdt) + σ 2 2 (t, Ut )Zt2 dt
∂t ∂y 2 ∂y
2 ∂h
−σ St (t, Ut )Zt dt.
∂y

we get
∂h ∂h


 rηt At + µξt St = µSt h(t, Ut ) − (µ − r)St Zt (t, Ut )dt + St (t, Ut )


 ∂y ∂t
1 ∂2h


+ St σ 2 Zt2 2 (t, Ut ),


2 ∂y






∂h



 ξt = h(t, Ut ) − Zt (t, Ut ),

∂y
hence
2
∂h 1 2∂ h

2
 rηt At = −rSt (ξt − h(t, Ut )) + St ∂t (t, Ut ) + 2 St σ ∂y 2 (t, Ut )Zt ,



 ξt = h(t, Ut ) − Zt ∂h (t, Ut ),



∂y
and
" 221

N. Privault
 2 2
1 2 1 − e−r(T −t)

∂h ∂ h
(t, y) + σ − y (t, y) = 0,



 ∂t
 2 rT ∂y 2
1 − e−r(T −t)

∂h



 ξt = h(t, Ut ) +
 − Ut (t, Ut ),
rT ∂y
h(T, z) = z + .

We also find
1 − e−r(T −t) ∂h

∂h
ηt At = er(T −t) St Ut − (t, Ut ) = St Zt (t, Ut ).
rT ∂y ∂y
Exercises
Exercise 8.1 Consider a risky asset whose price St is given by
dSt = σSt dBt + σ 2 St dt/2, (8.57)
where (Bt )t∈R+ is a standard Brownian motion.
1. Solve the stochastic differential equation (8.57).

2. Compute the expected stock price value E[ST ] at time T .
3. What is the probability distribution of the supremum sup Bt over the
t∈[0,T ]
interval [0, T ] ?
4. Compute the expected value E[ŜT ] of the maximum
!
σBt
ŜT := sup St = S0 sup e = S0 exp σ sup Bt .
t∈[0,T ] t∈[0,T ] t∈[0,T ]
of the stock price over the interval [0, T ].
Exercise 8.2 Recall that the maximum Xt := sups∈[0,t] Bs over [0, t] of stan-
dard Brownian motion (Bs )s∈[0,t] has the probability density
r
2 −x2 /(2t)
ϕXt (x) = e 1[0,∞) (x), x ∈ R.
πt
222 "

1. Let τa = inf{s ∈ R+ : Bs = a} denote the first hitting time of a > 0

by (Bs )s∈R+ . Using the relation between {τa ≤ t} and {Xt ≥ a}, write
down the probability P (τa ≤ t) as an integral from a to ∞.
2. Using integration by parts on [a, ∞), compute the probability density of
τa .
2 2
Hint: the derivative of e−x /(2t) with respect to x is −xe−x /(2t)
/t.
3. Compute the mean value E[(τa )−2 ] of 1/τa2 .
Exercise 8.3 Barrier options.

1. Compute the hedging strategy of the up-and-out barrier call option on
the underlying asset St with exercise date T , strike K and barrier B,
with B > K.
2. Compute the joint probability density
dP(YT ≤ a & BT ≤ b)
fYT ,BT (a, b) = , a, b ∈ R,
dadb
of standard Brownian motion BT and its minimum
YT = min Bt .
t∈[0,T ]
3. Compute the joint probability density
dP(ỸT ≤ a & B̃T ≤ b)

fỸT ,B̃T (a, b) = , a, b ∈ R,
dadb
of drifted Brownian motion B̃T = BT + µT and its minimum
ỸT = min B̃t = min (Bt + µt).

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

option on the underlying asset St with exercise date T , strike K, barrier
B, and payoff
S −K if min St > B,

 T
 0≤t≤T
+
C = (ST − K) 1( ) =
min St > B 0

if min St ≤ B,
0≤t≤T 0≤t≤T
in cases 0 K.
Exercise 8.4 Barrier forward contracts. Compute the price at time t of the
following barrier forward contracts on the underlying asset St with exercise
" 223

N. Privault
date T , strike K, barrier B, and the following payoffs. In addition, compute

the corresponding hedging strategies.
1. Up-and-in barrier long forward contract. Take
S − K if max St > B,

 T
 0≤t≤T
C = (ST − K) 1( ) =
max St > B 0

if max St ≤ B.
0≤t≤T 0≤t≤T
2. Up-and-out barrier long forward contract. Take
S − K if max St < B,

 T
 0≤t≤T
C = (ST − K) 1( ) =
max St < B 0

if max St ≥ B.
0≤t≤T 0≤t≤T
3. Down-and-in barrier long forward contract. Take
S − K if min St < B,

 T
 0≤t≤T
C = (ST − K) 1( ) =
min St B,

 T
 0≤t≤T
C = (ST − K) 1( ) =
min St > B 0

if min St ≤ B.
0≤t≤T 0≤t≤T
5. Up-and-in barrier short forward contract. Take
K − ST if max St > B,

0≤t≤T


C = (K − ST ) 1( ) =
max St > B 0

if max St ≤ B.
0≤t≤T 0≤t≤T
6. Up-and-out barrier short forward contract. Take
K − ST if max St < B,

0≤t≤T


C = (K − ST ) 1( ) =
max St < B 0

if max St ≥ B.
0≤t≤T 0≤t≤T
7. Down-and-in barrier short forward contract. Take
224 "

K − ST if min St < B,

0≤t≤T


C = (K − ST ) 1( ) =
min St B,

0≤t≤T


C = (K − ST ) 1( ) =
min St > B 0

if min St ≤ B.
0≤t≤T 0≤t≤T
Exercise 8.5 Consider a risky asset whose price St is given by
dSt = σSt dBt + σ 2 St dt/2,
where (Bt )t∈R+ is a standard Brownian motion.

1. What is the probability distribution (distribution function and probabil-
ity density function) of the minimum min Bt over the interval [0, T ]
t∈[0,T ]
?
2. Compute the price value

2
e−σ T /2
E ST − min St
t∈[0,T ]
of a lookback call option on ST with maturity T .
Exercise 8.6 Lookback options. Compute the hedging strategy of the look-
back put option priced in Proposition 8.4.
Exercise 8.7 Consider the short rate process rt = σBt , where (Bt )t∈R+ is a
standard Brownian motion.
rT
1. Find the probability distribution of the time integral 0 rs ds.
2. Compute the price
wT
" + #
e−rT IE ru du − κ
0
rT
of a caplet on the forward rate 0
rs ds.
Exercise 8.8 Asian call options with negative strike. Consider the asset price
process
" 225

N. Privault
2
St = S0 ert+σBt −σ t/2
, t ∈ R+ ,
where (Bt )t∈R+ is a standard Brownian motion. Assuming that κ ≤ 0, com-
pute the price
1 wT
" + #
e−r(T −t) IE∗ Su du − κ Ft
T 0
of the Asian option at time t ∈ [0, T ].
Exercise 8.9 Pricing of Asian options by PDEs. Show that the functions
g(t, z) and h(t, y) are linked by the relation
1 − e−r(T −t)

g(t, z) = h t, + e−r(T −t) z , t ∈ [0, T ], z > 0,
rT
and that the PDE (1.35) for h(t, y) can be derived from the PDE (1.33) for
g(t, z) and the above relation.
226 "

Exoticoptions

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Exoticoptions

Uploaded by

Copyright:

Available Formats

Chapter 8

In this chapter we work in a continuous geometric Brownian model in which

dSt = rSt dt + σSt dBt , t ∈ R+ ,

An option with payoff C = φ(ST ) can be priced as

Recall that typically we have

for a European call option with strike K, and

for a binary call option with strike K.

of the underlying price process instead of its terminal value ST . Next we

is the maximum of (St )t∈R+ over the time interval [0, T ].

This version: April 24, 2013

Fig. 8.1: Brownian motion Bt and its supremum Xt .

The payoff of an up-and-out barrier put option on the underlying asset St

The payoff of a down-and-out barrier call option on the underlying asset

(S − K)+ if min St > B,

This version: April 24, 2013

In this case we can take

Fig. 8.2: Brownian motion Bt and its moving average.

This version: April 24, 2013

8.2 The Reflexion Principle

In such situations the option price at time t = 0 can be expressed as

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

This version: April 24, 2013

Maximum of Standard Brownian Motion

Let (Bt )t∈R+ denote a standard Brownian motion started at B0 = 0. While

Given a > B0 = 0, let

Due to the space symmetry of Brownian motion we have the identity

2P(BT > a & XT ≥ a) = P(τa < T ) = 2P(BT < a & XT ≥ a),

due to the equivalence

{XT ≥ a} = {τa < T }. (8.1)

In other words, we have

P(XT ≥ a) = P(BT > a & XT ≥ a) + P(BT < a & XT ≥ a)

This version: April 24, 2013

= P(BT > a) + P(BT < −a)

where we used the fact that

{BT > a} ⊂ {BT > a & XT ≥ a} ⊂ {BT > a}.

Fig. 8.3: Reflected Brownian motion with a = 1.

Consequently, the maximum XT of Brownian motion has same distribution as

This version: April 24, 2013

Using the density of XT we can price an option with payoff φ(XT ), as

since σ > 0. When the payoff takes the form

e−rT IE [C] = e−rT IE φ(S0 eσXT )

This version: April 24, 2013

P(BT > a + (a − b) | τa < T ) = P(BT < b | τa < T ),

P(BT > 2a − b & XT ≥ a) = P(BT < b & XT ≥ a),

P(BT ≥ 2a − b) = P(BT > 2a − b & XT ≥ a) = P(BT < b & XT ≥ a), (8.3)

where we used the fact that

{BT ≥ 2a − b} ⊂ {BT > 2a − b & XT ≥ 2a − b}

which shows that {BT ≥ 2a − b} = {BT > 2a − b & XT ≥ a}.

Hence by (8.3) we have

dP(XT ≥ a & BT ≤ b) dP(XT ≤ a & BT ≤ b)

This version: April 24, 2013

a, b ∈ R, by (16.15), i.e., letting a ∨ b := max(a, b),

Maximum of Drifted Brownian Motion

Using the Girsanov theorem, it is even possible to compute the probability

X̃T = max B̃t = max (Bt + µt)

of the drifted Brownian motion B̃t = Bt + µt, µ ∈ R. The arguments previ-

This version: April 24, 2013

hence the density of X̃T under P̃ is given by (8.4).

Now, using the density (8.5) we get

dP(X̃T ≤ a & B̃T ≤ b)

1 w a  µy−y2 /(2T )−µ2 T /2

This version: April 24, 2013

Fig. 8.6: Probability density of the maximum of drifted Brownian motion.

1 w a µy−y2 /(2T )−µ2 T /2