The valuation of American barrier options using the decomposition technique

Bin Gao, Jing Zhi Huang, Marti Subrahmanyam

Research output: Contribution to journalArticle

51 Scopus citations

Abstract

In this paper, we propose an alternative approach for pricing and hedging American barrier options. Specifically, we obtain an analytic representation for the value and hedge parameters of barrier options, using the decomposition technique of separating the European option value from the early exercise premium. This allows us to identify some new put-call 'symmetry' relations and the homogeneity in price parameters of the optimal exercise boundary. These properties can be utilized to increase the computational efficiency of our method in pricing and hedging American options. Our implementation of the obtained solution indicates that the proposed approach is both efficient and accurate in computing option values and option hedge parameters. Our numerical results also demonstrate that the approach dominates the existing lattice methods in both accuracy and efficiency. In particular, the method is free of the difficulty that existing numerical methods have in dealing with spot prices in the proximity of the barrier, the case where the barrier options are most problematic.

Original languageEnglish (US)
Pages (from-to)1783-1827
Number of pages45
JournalJournal of Economic Dynamics and Control
Volume24
Issue number11-12
DOIs
StatePublished - Oct 2000

All Science Journal Classification (ASJC) codes

  • Economics and Econometrics
  • Control and Optimization
  • Applied Mathematics

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