Static Hedging and Pricing American Knock-Out Options

Posted: 2 May 2017

See all articles by Chung San-Lin

Chung San-Lin

National Taiwan University

Pai-Ta Shih

Department of Finance, National Taiwan University

Wei-Che Tsai

Oregon State University; National Sun Yat-sen University - Department of Finance

Date Written: January 2, 2013

Abstract

This paper extends the static hedge portfolio (SHP) approach of Derman, Ergener, and Kani (1995) and Carr, Ellis, and Gupta (1998) to price and/or hedge American knock-out options. We construct a SHP to match the complicated boundary conditions of American barrier options. Detailed analyses of the profit and loss distributions suggest that the hedging effectiveness of a bi-monthly SHP is far less risky than that of a delta-hedging portfolio with daily rebalance. Moreover, numerical results indicate that the efficiency of the proposed method is comparable to Boyle and Tian (1999) for pricing American knock-out options under the constant elasticity of variance (CEV) model of Cox (1975). In particular, the recalculation of the option prices and hedge ratios under the proposed method is much easier and quicker than the tree methods.

Keywords: Static hedge; American barrier options; Value-matching condition; Smooth-pasting condition

JEL Classification: G13

Suggested Citation

San-Lin, Chung and Shih, Pai-Ta and Tsai, Wei-Che, Static Hedging and Pricing American Knock-Out Options (January 2, 2013). Journal of Derivatives, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2961143

Chung San-Lin

National Taiwan University ( email )

21 Hsiu Chow Rd
Taipei, 10020
Taiwan

Pai-Ta Shih

Department of Finance, National Taiwan University ( email )

1, Sec. 4, Roosevelt Road
Taipei, 106
Taiwan

Wei-Che Tsai (Contact Author)

Oregon State University ( email )

Corvallis, OR 97331
United States

National Sun Yat-sen University - Department of Finance ( email )

No.70, Lianhai Rd., Gushan District,
Kaohsiung City
Taiwan

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