Static Hedging and Pricing American Knock-Out Options
Posted: 2 May 2017
Date Written: January 2, 2013
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: Suggested Citation