Examples from Chapter 10: bull spreads, bear spreads, straddles, etc Often structured to have zero cost One popular package is a range forward contract
(Bermudans) Early exercise allowed during only part of life (initial “lock out” period) Strike price changes over the life (warrants, convertibles)
From put - call parity r (T2 T1 ) q (T2 T1 ) p ce K S1e The value at time T1 is therefore c e q (T2 T1 ) max( 0, Ke( r q )(T2 T1 ) S1 ) This is a call maturing at time T2 plus a put maturing at time T1
dividend paying stock where S0 = 50, K = 50, the barrier is 60, r = 10%, and = 30% Any boundary can be chosen but the natural one is c (S, 0.75) = MAX(S – 50, 0) when S < 60 c (60, t ) = 0 when 0 t 0.75
compared with 0.31 for the up-and out option As we use more options the value of the replicating portfolio converges to the value of the exotic option For example, with 18 points matched on the horizontal boundary the value of the replicating portfolio reduces to 0.38; with 100 points being matched it reduces to 0.32