Financial Markets & Financial Instrument Candidate No.

- 66528

University of Sussex

School of Business and Management

Financial Markets & Financial Instruments

Report Writing:-

Barrier Option.

Candidate Number - 66528

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Financial Markets & Financial Instrument Candidate No. - 66528

Abstract

This article discuss in detail on various aspect of Barrier options, which is an exotic

financial derivative. This paper starts with brief description of financial derivatives,

Options, Barrier Options and its types, pricing and conclusion.

Introduction

According to Merriam – Webster Dictionary defines derivatives in chemistry as “ a

substance that can be made of another substance”. And Derivatives in Finance

works on the same fundamental. Now these financial instruments works on the

above principal and promise payoffs which are being gained from the value of some

other thing which is known as an underlying asset (real goods or stocks) (Stulz,

Pg.20). And in the simple form it is a contract between the two parties to exchange

the value based on the movement of the real goods and services. And the seller

receives certain amount in case of a buy or sell of various goods and services on a

specified future date agreed by the both the parties. And as coins have two sides

financial derivatives have two sides. They are quite dangerous but if handled

properly they have proved to be the most valuable for the economy and will always

be. (Stulz, Pg.22).

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Options

As per the definition in Investopedia “An option is a contract that gives the buyer

the right, but not the obligation, to buy or sell an underlying asset at a specific price

on or before a certain date. An option, just like a stock or bond, is a security. It is also

a binding contract with strictly defined terms and properties.”

And this report majorly puts light on the Barrier Option (exotic option) its different
types & a simple methodology in which the valuation of the barrier option is carried
out.

arrier Option have become very much prominent in many over-the-

counter markets. And it has become so much popular because of its

flexibility and also because of the lower extrinsic value as compared

to the vanilla option. (Carr, 1995, Pg.1).

arrier option are a type of financial option where the right to exercise

the option totally depends on the underlying crossing or reaching a

Barrier level. And they are always carries a lower extrinsic value as

compared to the vanilla option. They are also known as the path-

dependent option which are some or the other way similar to the normal option with

some variation. (Carr & Chou, 2002, pg .2).

And also there are two variations in barrier option, not only in barrier option but

it’s a concept which is followed in each and every derivatives. According to the

Finance.com, the key difference between American and European options relates to

when the options can be exercised:

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• “A European option can be exercised only during the time of its expiry, & not

before that, of the option which means that it has a pre-decided time for its

expiration

• An American option can be exercised at any point of time unlike the European

option, there is no such pre-decided time to exercise it. But it has a pre-

decided time for expiration.”

Option contracts which are traded on futex i.e. future exchanges are generally of

American-style, on the other hand those traded over-the-counter are generally of

European style.

Expiration date :-

• The expiration of American option is on the third Saturday of every month.

Also the trading is closed on Friday before the third Saturday .

• And the expiration of the European options is on the third Friday of every

month. Therefore they are closed for trading on the Thursday before the

closing day .( Finance.com)

Now moving on to the types of Barrier Option. Barrier Option can be “ in ” option

or “ out ” option, which can also be termed as “knock-in” and “knock-out” option.

Knock-in option means that the option becomes active only when it reaches a

certain barrier level, but if it fails to reach that level/ barrier during the life of the

option it becomes worthless. Initially the life of “In” option is worthless but once it

reaches or crosses the barrier it becomes active and give right to the holder to

exercise it, either to buy or to sell (if it is a call, or if it is a put respectively).

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For eg:- Let’s suppose if you buy a Knock in call option with £100 (Strike price),

which has a predefined barrier at £120, when the actual/ underlying asset of

which the knock in call option is trading around £80. It keeps fluctuating but at the

end of the expiry if it closes above the strike price say £110 it becomes worthless

because it does not crosses the barrier of £120. ( Derman & Kani, 1996, pg.56).

But Knock out option is totally opposite of the knock in option. Knock out option

means the option becomes worthless as soon as the asset prices reaches or

crosses the barrier level. Unlike Knock in option, Knock out option are active

initially but becomes worthless once the barrier price is reached.

For Eg :- let’s suppose you buy a Knock out call option at £100 (strike option)

with a predefined barrier at £120, when the actual/ underlying asset of which the

knock out call option is trading around £80. It keeps fluctuating but at the end of

the expiry if it closes at £125 though it is above the strike price it becomes

worthless because it crossed the barrier of £120. ( Derman & Kani, 1996, pg.56).

Down and Out Option - A down and out barrier option is a option which allow

the holder/buyer of the option to buy or sell but there is no obligation, if it’s a call

or put respectively, the underlying assets share which have a predetermined

strike price as long as the barrier level is not crossed by the price of the asset

before its expiry date. But once the price of the asset goes below the barrier level

is worthless/ Knocked out . In down and out option the barrier is set below the

strike price of the option. (Kolb and Overdahl, 2007)

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Up and Out Option :- It is almost same as the Down & Out option but the only

difference between Down and Out Option & Up and out option is that the barrier

in the former one is set below the spot price but in latter the barrier is set above

the spot price and unlike down & up it gets knocked out if the price of the

underlying assets rises and crosses the barrier level. (Kolb and overdahl, 2007)

Down and In Option :- Unlike Down and out , it is totally opposite. In this the

option gives the right to the holder to exercise it once it crosses the pre-

determined barrier level. Once the price of the underlying assets crosses the

barrier it becomes active/ Knock in. But it knocks in only if it falls below the barrier

level and if it doesn’t fall below the barrier level during the option life time it

becomes worthless. And in this the barrier level is set below the strike price of the

option. (Beaglehole,1992)

Up and In Option :- This option works in a similar manner, the way the up & out

option works . As the barrier is placed above the strike price of the underlying

asset. But the only difference is that if the price of the underlying asset crosses

the barrier level it becomes active and doesn’t become worthless.

(Beaglehole,1992)

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Pricing

Barrier Option pricing is path dependent, it means that it not only relies on the price

of the underlying asset (as in the case of the plain vanilla options), but also on the

path taken by underlying asset price during the given period of time.

Closed Form Solution was very early model developed to calculate the pricing of

barrier options. Earlier Merton(1973, cited in Cheng, 2003 ) formulized for the down

and out option, and latter on the Reiner and Rubinsten(1991 cited in cited in Cheng

2003) gave generalized formulas for all 8 types of barrier options. This was

developed under Black Scholes Model Framework which assumed that underlying

asset price follows Geometric Brownian Motion /Lognormal process (i.e Continuous

prices)(Cheng 2003, pp.2:14).

Another Model put forth was Continuity Correction by Broadie, Glasserman and Kou

considering that the underlying asset price will takes discrete values rather than the

continuous lognormal distribution. Further few models were developed like Binomial,

Trinomial and Adaptive mesh models which placed the barrier at lattice tree fashion,

But the empirical results showed that there was slow convergence rate because

barrier used by the tree was generally different from true barrier value(Cheng 2003,

pp.2:14).

Some of the drawbacks of Black Scholes Model assumptions were that stock prices

will follow continuous log normal process, but in the reality underlying stock prices

can have a discrete values as well as they may take up the extreme values when

some related news is disclosed. The paper presented by Mitov, Rachen, Kim and

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Fabozzi overcame above drawback and provided model to calculate the option

prices when stock price is modelled by Branch Process Random environment.

Empirical results shows that option prices calculated under this model are higher

than that of generated by log normal process while there are longer times to

expiration (Mitov, Rachev, Kim and Fabozzi (2009)).

Barrier options have cheaper premium compared to plain vanilla option under certain

condition, hence preferred candidate for large investment or hedging. Also owner

can benefit not only by exercising the option, but also by selling the option as higher

premium price. Below is comparison between the Vanilla and a different types

Barrier option pricing for European style where rebate is 0.

S:Stock Price, K:Strike Price, H:Barrier ,V:Volatility,RFR:risk Free rate =10%

Barrier Option Std call BO call Std put BO put

Option Type Description(RFR=10%) Value value value value

Out S=100,K=100,H=90,V=15% 7.84 7.222 3.749 0.286

In S=100,K=100,H=90,V=15% 7.84 0.618 3.749 3.463

Up-And-Out S=100,K=100,H=120,V=25% 11.434 0.657 7.344 6.705

Up-And-In S=100,K=100,H=120,V=25% 11.434 10.779 7.344 0.639

Table: 1, Source: Derman, Kani(1996, pp 59: 60).

From the above table, we can see that Down-and-out call option price is almost

similar to that of standard call option, while there is significant difference between

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Standard Put option and Down-Out Put option prices. This is because as the price

moves down std put option becomes deep in money and is more profitable, while

Barrier option of this type have a chances that if it cross the down barrier it might

become worthless.

If we will consider the Down-And-In Case where specific barrier option is much less

compared to its standard counterpart because Down-&-in call will get active only if

stock has made significant downward movement and crossed the barrier which is not

favourable for the standard call option.

Options Sensitivities

Some of the variables affecting the Option pricing are Stock prices/Asset Price,

Volatility and Time to maturity. The Greeks measuring these sensitivities are as

follows.

Delta: It is Options sensitivity to small movements in the underlying asset prices.

Gamma: It is the estimation of the change in delta for1 point change in Stock price ,

it as an second derivative of delta.

Vega: It is options price sensitivity to the volatility of the stock(or an underlying

asset).It represent change in the option price with

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Generally Options are most affected to change in the volatility of the underlying asset

price when they are at-the-money and not (or least) affected when they are out-the-

money and in-the-money. But this case may not be the same in case of barrier

options, because too deep in money or out-the-money they might not be active or

get knocked off.

Theta: It measures the options sensitivity to time to maturity.

Above Definitions are provided by Haug(1998, p.11-14).

Sensitivity parameter behave differently for standard vanilla and barrier options,

moreover it changes behaviour near the barrier where possibility of getting knock in

or knock out is high. We will look into this details with respect to delta.

Below graphs have plotted data for delta values and option prices for the Standard

and various barrier option for 0 rebate.

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Graph: 1, Source: Derman and Kani(1996, pp 61: 64).

Graph: 2, Source: Derman and Kani(1996, pp 61: 64). Graph: 3, Source: Derman

and Kani(1996, pp 61:64).

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Graph: 4, Source: Derman and Kani(1996, pp 61: 64).

Graph: 5, Source: Derman and Kani(1996, pp 61: 64).

Graph 1 plots Option price values and delta values against stock prices in Panel A

and Panel B respectively for standard call, similarly Graph 2,3,4 and 5 illustrates

various Barrier options.

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From the above we can see that sensitivities of barrier options differ from those of

standard options. For ex. In Down-and-out call option delta is 0 below the barrier

and inflates rapidly just above it. While if we look at Down-and-in option, below the

barrier delta behave similarly to std call option, but just above it, delta becomes

negative since increasing stock price decreases possibility of an option getting

activated i.e knocked in. Similarly in Up-and-out call option as stock price moves up,

payoff potentially becomes larger, but deep in money also increase the possibility of

option getting knocked out, hence delta turn negative from positive near the barrier

option(Derman and Kani(1996, pp 61: 64).

Conclusion:

Barrier Options are modified form of vanilla options, involving barriers at the different

points and getting activated or terminated as per the underlying event. They are

mostly used for investments and hedging in OTC markets, This paper discussed

about various types of the Barrier options, Models used for pricing and changes in

their prices as per market conditions.

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Bibliography:

Beaglehole.D, (1992). ‘Down and Out, Up and In Options’, University of

Carr,P. (1995). ‘Two Extensions to Barrier Option Valuation’. Cornell Univeristy.

Carr.P & Chou.A (2002). ‘Hedging Complex Barrier Options’. New York Univesity

Cheng, A (2003) 'An overview of Barrier Options', Available from: http://www.global-

Derman.E & Kani.I, (1996). ‘The Ins and Outs of Barrier Option : Part 1’, Derivatives
Quaterly.

Exercisable or Knock-in Options. (2010). Derivatives,FRM level II, available from

Kolb.R & Overdahl.J (2007). Futures, Options and Swaps. The United Kingdom, Blackwell
Publishing

Mitov, G.K. Rachev, S.T, Kim,Y.S and Fabozzi, F.J. (2009) ‘BARRIER OPTION PRICING
BY BRANCHING PROCESSES’, International Journal of Theoretical and Applied Finance,
12(7), pp.1057.

Stulz,R.M.(2005). ‘Demystifying financial Derivatives. Third Quarter’, available from

‘What Are Options’, Available from

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