UPPSALA DISSERTATIONS IN MATHEMATICS

45
On the pricing equations of
some path-dependent options
Jonatan Eriksson
Department of Mathematics
Uppsala University
UPPSALA 2006
Dissertation presented at Uppsala University to be publicly examined in MIC2247, Uppsala,
Friday, March 17, 2006 at 13:15 Ior the degree oI Doctor oI Philosophy. The examination will
be conducted in English.

Eriksson, J. 2006. On the pricing equations oI some path-dependent options. Uppsala

Dissertations in Mathematics 45. vi18 pp. Uppsala. ISBN 91-506-1852-0.
This thesis consists oI Iour papers and a summary. The common topic oI the included papers
are the pricing equations oI path-dependent options. Various properties oI barrier options and
American options are studied, such as convexity oI option prices, the size oI the continuation
region in American option pricing and pricing Iormulas Ior turbo warrants. In Paper I we
study the eIIect oI model misspeciIication on barrier option pricing. It turns out that, as in the
case oI ordinary European and American options, this is closely related to convexity
properties oI the option prices. We show that barrier option prices are convex under certain
conditions on the contract Iunction and on the relation between the risk-Iree rate oI return and
the dividend rate. In Paper II a new condition is given to ensure that the early exercise Ieature
in American option pricing has a positive value. We give necessary and suIIicient conditions
Ior the American option price to coincide with the corresponding European option price in at
least one diIIusion model. In Paper III we study parabolic obstacle problems related to
American option pricing and in particular the size oI the non-coincidence set. The main result
is that iI the boundary oI the set oI points where the obstacle is a strict subsolution to the
diIIerential equation is C
1
-Dini in space and Lipschitz in time, there is a positive distance,
which is uniIorm in space, between the boundary oI this set and the boundary oI the
non-coincidence set. In Paper IV we derive explicit pricing Iormulas Ior turbo warrants under
the classical Black-Scholes assumptions.
Keyworas. Parabolic partial diIIerential equations, variational inequalities, American options,
barrier options, monotonicity in the volatility, turbo warrants, pricing Iormulas
Jonatan Eriksson, Department of Mathematics, Box 480, Uppsala University, SE-75106
Uppsala, Sweaen
Jonatan Eriksson 2006
ISSN 1401-2049
ISBN 91-506-1852-0
urn:nbn:se:uu:diva-6329 (http://urn.kb.se/resolve?urnurn:nbn:se:uu:diva-6329)
List of Papers
This thesis is based on the following papers, which are referred to in the text
by their Roman numerals.
I Eriksson, J. (2005) Monotonicity in the volatility of single-barrier
option prices, to appear in the Int. J. Theor. Appl. Finance.
II Eriksson, J. (2005) When American options are European, sub-
mitted to Decis. Econ. Finance.
III Arnarson, T., Eriksson, J. (2005) On the size of the
non-coincidence set of parabolic obstacle problems with
applications to American option pricing, submitted to Math.
Scand.
IV Eriksson, J. (2005) Explicit pricing formulas for turbo warrants,
submitted to Risk magazine.
Reprints were made with permission from the publishers.
Contents
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Option pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Path-dependent European options . . . . . . . . . . . . . . . . . . . . . . 2
1.3 Parabolic obstacle problems and free boundary problems . . . . . 3
1.4 American options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2 Included papers and description of the results . . . . . . . . . . . . . . . . . 7
2.1 Paper I . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1.1 Knock-out options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.1.2 Knock-in options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.2 Paper II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3 Paper III . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.4 Paper IV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Sammanfattning p svenska (Summary in Swedish) . . . . . . . . . . . . . . . 13
Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1. Introduction
In this thesis we study nancial mathematics in continuous time. This disci-
pline of science is typically concerned with the problem of pricing and hedg-
ing nancial instruments dened in terms of some underlying asset. Exam-
ples of such instruments are stock-options and warrants. The value of a stock-
option or a warrant is given as the discounted expected future pay-off, but
since the value of the underlying asset typically is unknown at future times,
the pay-off is too. The price-evolution has to be modeled with stochastic pro-
cesses. However, for the purpose of option pricing not any stochastic process
will do, but there are strict theoretical rules the asset process has to obey to
avoid arbitrage in the market. The discounted asset price has to be a martin-
gale when pricing nancial instruments. The common way of modeling asset
prices is to use Brownian motion and more generally solutions to stochas-
tic differential equations. In this context the problem of option valuation is
similar to problems of heat conduction and particle motion in physics since
expected values of functions of solutions to stochastic differential equations
solve parabolic partial differential equations similar to the heat equation. Prob-
lems in nance are however very different in their nature from their physical
counterparts. In nance, the volatility of the stock, which roughly is the same
as the diffusion coefcient in physics, is most certainly unknown and one has
to rely on historical data and educated guesses.
The implications of model misspecication and misspecication of the
volatility are important and questions about robustness which arise due to the
uncertainty of the volatility are connected to properties of the Black-Scholes
partial differential equation and preservation of convexity of solution to that
equation, compare [14] and [15].
1.1 Option pricing
In the two seminal papers [3] and [19] the authors describes how to price op-
tions on a market with one risky asset and one risk-free asset, such that the
no-arbitrage principle holds. An arbitrage opportunity is a risk-free invest-
ment strategy, with zero initial endowment, in nancial instruments such as
stocks, bonds and options, such that the nal wealth is non-negative almost
surely and positive with positive probability. The no-arbitrage principle says
that a nancial market should contain no arbitrage opportunities. The result
in the above mentioned papers can be formulated as follows: Assume that
1
the market consists of two trades assets B(t) and S(t) evolving according to
dB(t) = rB(t)dt and dS(t) = S(t)dt +S(t)dW(t) where the constants are
r 0, the interest rate, , the appreciation rate and , the volatility, and where
W is a standard Brownian motion. Then the only price of an option at time t,
paying (S(T)) at some future time T, and which does not introduce arbi-
trage in the market is the discounted expected value of (S(T)). However, the
expectation is not calculated under the real-world measure P which is used
to describe the dynamics of S but under the so-called risk-neutral measure Q.
This measure is dened as the unique measure making the discounted stock-
price a martingale, and the appreciation rate of S(t) under this measure is r.
By using the explicit expression for the stock-price process under the measure
Q
S(T) = S(t)e
(r
1
2

2
)(Tt)+(W
Q
T
W
Q
t
)
and by using that the increment of a Brownian motion is normally distributed
with variance equal to the length of the increment, the expected value for the
price
V(s, t) = E
s,t
e
r(Tt)
(S(T))
can be calculated explicit in terms of the normal distribution function. The
results is the famous Black-Scholes formula which was derived for the call-
option, (s) = (s K)
+
, and for the put-option, (s) = (Ks)
+
, in the above
mentioned papers.
By the Feynman-Kac representation formula for solutions to parabolic dif-
ferential equations, the price V(s, t) can also be computed as the solution to
the Black-Scholes equation
1
2

2
s
2

2
V
s
2
+rs
V
s
rV +
V
t
= 0
together with the nal value V(s, T) = (s), compare [13]. We note that the
term
V
t
has the opposite sign of the corresponding term in the heat equation.
This is consistent with our specifying a nal condition rather than an initial
condition as in physics.
1.2 Path-dependent European options
A European vanilla option is an option with a pay-off that only depends on
the stock-price at maturity T. The pay-off can be described as (S(T)) for
some contract function . A European path-dependent option is an option
whose pay-off at maturity T depends on the whole path of the stock-price
S(t) between t = 0 and t = T. Examples of such options are Asian options,
which depend on the average of the stock-price, Barrier options and lookback
options, which depend on the maximum and/or the minimum of the stock-
price.
2
The most common types of barrier options are knock-in options and knock-
out options. As their names suggest a knock-in option is activated when a
prescribed barrier is hit by the stock-price, and a knock-out option is extin-
guished when the barrier is hit. Depending on the relation between the initial
stock-price and the barrier these options are usually given names like up-and-
out option, up-and-in option, down-and-out option and down-and-in option.
The theory of pricing barrier options goes back to [19] where a down-and-
out option is priced under geometrical Brownian motion. A more complete
pricing scheme in this case can be found in [21] where the authors make clever
combinations of the distribution functions of absorbed geometrical Brownian
motions to generate prices for a large numbers of single-barrier options. Com-
pare also [22].
In the paper [22] a sensitivity analysis is performed for barrier options of
call and put types (see also [24]), i.e. a calculation of the options (sensitivity
to movements in the underlying stock) and (sensitivity of to movements
in the underlying stock), which is of great interest when performing dynamic
hedging. Especially the sign of is important when it comes to the effect on
the hedging portfolio of a misspecied volatility. For European vanilla options
and for American options it is well-known that convexity of the contract func-
tion is enough to ensure a positive which in turn ensures a super-hedging
portfolio if the volatility is overestimated, compare [11], [14], [13], [9] and
[10]. However, when it comes to barrier options the situation can be very
different. Here convexity depends not only on the convexity of the contract
function but also on the underlying process and the barrier. This comes as
no surprise since an (almost trivial) example of a barrier option with convex
contract function and non-convex price is an up-and-out put option with the
barrier in-the-money, i.e. the option has non-zero intrinsic value at the barrier.
For certain other types of barrier options convexity is preserved and this is one
of the themes in the thesis and constitutes the content of Paper I.
A new kind of barrier option called turbo warrant is studied in Paper IV.
This instrument is essentially a call or a put option with a barrier in-the-money
and a non-constant rebate which is activated if the barrier is hit prior to ma-
turity. This means that if the option is knocked out a small sum is paid to the
warrant holder. In the call-case the rebate is given by the difference of the low-
est recorded stock-price during a three-hour period after the knock-out event
and the strike price. In the put-case it is the highest recorded stock-price which
determines the rebate.
1.3 Parabolic obstacle problems and free boundary
problems
In a free boundary problem one seeks the solution to a differential equation
Mf = 0, in some domain where only a part S of the boundary is given,
3
whereas the remaining portion is not a priori prescribed. On the boundary
of some boundary conditions f = are given. To get a well-posed problem
an additional condition is given on . This additional boundary condition de-
pends on the particular problem in question, and in nancial applications the
condition is the so-called high-contact principle ,
x
f =
x
. A solution to a
free boundary problem consists of the function f and of the free boundary .
A special class of free boundary problems are the ones which can be written
as obstacle problems, for instance as the minimization of a functional over a
closed convex set K = { f H : f } in a suitable function space H. Here
the a priori given function is referred to as the obstacle. The main difference
between a general free boundary problem and an obstacle problem is that in
an obstacle problem one can analyze the solution without having to analyze
the free boundary at the same time.
When studying obstacle problems it is often useful to write the problem as
a so-called complementary problem

Mf 0,
( f )Mf = 0,
f ,
where M is a differential operator corresponding to the above minimization
problem. The obstacle problem now becomes to nd a function in a suitable
function space, e.g. in the Sobolev space W
2,1
q
, satisfying the above inequal-
ities in a weak sense such as almost surely, as distributions or in a viscos-
ity sense. The free boundary in the obstacle problem is the set = {(s, t) :
f (s, t) >(s, t)}, and under some appropriate regularity assumptions the solu-
tion f satises the so-called principle of smooth t on , that is, the mapping
x
x
( f ) is continuous across , at least at points where is continu-
ously differentiable. Intuitively the principle of smooth t is clear, since it in
nancial applications means that the number of shares of the underlying stock
to be held in the hedging portfolio does not jump when the stock passes into
the stopping region.
Apart from nancial applications, obstacle problems arise naturally in
physics and mechanics. Examples of such situations are:
1. The description of a weightless elastic membrane subject to shape change
under constraint.
2. Lubrication with oil between two surfaces.
3. Melting of ice in water. This problem is however not directly given as an
obstacle problem, rather as a one-phase Stefan problem, but it can be re-
duced to an obstacle problem.
4
1.4 American options
An American option, unlike a European option, can be exercised at any time
prior to the maturity time T. This means that at any instant in time the holder
of the option needs to decide if to exercise or to hold the option. This extra
complexity in the problem results in the fact that explicit pricing formulas
rarely exists. Only in special cases such as if the American option has the
same value as the corresponding European option or if the maturity time is
innite is the price explicitly known, compare [11], [25], [20], [7] and Paper
II.
Suppose that the contract function is , then if the holder decides to exercise
at time the received amount is (S()). In the papers [1] and [16] it is shown
that the unique arbitrage free price V
A
at time t of an American option with
contract function is given by the optimal stopping problem
V
A
(s, t) = sup
F[t,T]
E
s,t
e
r(t)
(S()),
where the supremum is taken over all stopping times with respect to the l-
tration generated by the driving Brownian motion of S(t). Since the decision
on exercising or holding the option only can be based on past information it
is intuitively clear that the supremum only can be taken over the above men-
tioned stopping times. Notice also that V
A
always satises V
A
(s, t) (s) and
V
A
(s, t) V(s, t) since it is allowed to exercise the option either at t or at T. Be-
sides calculating the price of the option it is also interesting to decide a good
strategy for the option holder. That is to nd a stopping time

realizing the
supremum above. Intuitively it is clear that if V
A
(S(t), t) >(S(t)) it is not op-
timal to exercise the option since V
A
(S(t), t) corresponds to holding the option
and (S(t)) corresponds to exercising. In Appendix D in [17] it shown that
an optimal stopping time is given by

= inf{u t : V
A
(S(u), u) = (S(u))},
thus the optimal time to exercise the option is when the process (S(t), t) leaves
the continuation region
C ={(s, t) : V
A
(s, t) > (s)}.
There is another way of characterizing the American option price. In the
book [2] the connection between optimal stopping problems and free bound-
ary problems is established and for the American option pricing problem it
can be shown that V
A
satises Black-Scholes equation at every point in the in-
terior of the continuation region and that it is continuous on the whole domain.
Moreover, since V
A
and since V
A
=0 on the free boundary the solution
also satises the principle of smooth t there if it is regular enough. Thus the
American option pricing problem can be viewed as a free boundary problem
where the free boundary is the boundary of C. This free boundary problem
can be rewritten as an obstacle problem where the contract function is the
obstacle and where the inequality MV
A
0 holds on the whole domain and
where MV
A
= 0 holds on the continuation region C.
5
When it comes to the free boundary itself, not very much is known in the
general case. Questions of regularity are in general difcult to answer. Qual-
itative results on the behavior of the boundary in the multi-dimensional case
close to maturity are given in [23] and on the shape in [25], [20]. However, in
the special case of a one-dimensional geometric Brownian motion there has
been a lot of work done. Recently it was shown that the boundary is a convex
C

function of time, compare [8], [5] and [6].

Due to the difculty of nding the continuation region one is often inter-
ested in either approximations or of nding non-trivial subsets in which one
knows not to exercise the option, compare Paper III.
6
2. Included papers and description of
the results
2.1 Paper I
In this paper we study single-barrier options. The main question is: Under
which conditions can we guarantee that a convex contract function gives
rise to a convex price, i.e. that the options is non-negative? Other
questions answered in this paper are: When is super-hedging with volatility
over-estimation possible? What can be said about the options sensitivity to
movements in the underlying asset, i.e. the options ?
A barrier option is an option which gives a certain pay-off at maturity T
conditioned on some afore-hand determined behavior of the underlying asset.
Given a contract function and a barrier b > 0, a typical barrier option is any
of the following:
A down-and-out option. It pays (S(T)) at maturity T if the underlying
asset S(t) stays above b for all times t T.
A down-and-in option. It pays (S(T)) at T if the barrier is hit from above
at some time [0, T].
An up-and-out option. It pays (S(T)) at T if the underlying asset stays
below b for all times t T.
An up-and-in option. It pays (S(T)) at T if the barrier is hit from below
at some time [0, T].
If the conditions above are not satised, nothing is paid to the holder. The
techniques used in this paper are borrowed from the paper [15] and the main
idea is to use the maximum principle to show that the convexity of the nal
value is preserved by the option price. In the paper the underlying asset is
assumed to solve an SDE of the form
dS(t) = (r )S(t)dt +(S(t), t)S(t)dW(t)
where the diffusion coefcient (s, t) := s(s, t) is Hlder(1/2) in space and
continuous in time and the risk-free rate of return and the dividend rate are
constants.
7
2.1.1 Knock-out options
Consider the case of knock-out options. By introducing the stopping time
b
=
inf{t 0 : S(t) = b} we may describe the pay-off at maturity as
(S(T))1
{
b
>T}
.
The pay-off clearly depends on the whole trajectory of S(t). By risk-neutral
valuation the unique arbitrage-free value of the up-and-out option is given by
U(s, t) = E
s,t
e
r(Tt)
(S(T))1
{
b
>T}
.
Knowing that the option is not yet knocked out, the value function U(s, t) sat-
ises Black-Scholes equation, but with the extra boundary condition U(b, t) =
0 for t [0, T]. Depending on if it is a down-and-out option or a up-and-out
option the option is alive on s > b or s < b respectively. One of the results in
Paper I answers the rst of the above questions for knock-out options.
Theorem 1 (Convexity of knock-out options) Assume that the contract
function is convex on [0, ) and zero at the barrier. Then a down-and-out
option has a positive if the interest rate is dominated by the dividend rate
and an up-and-out option has a positive if the dividend rate is dominated by
the interest rate.
It is worth to notice that if the relation between r and goes in the wrong
direction, a convex contract function which is zero at the barrier need not give
rise to a convex price. Thus the theorem may fail if r < . The other two
questions posed in the beginning are answered in the following corollaries.
Corollary 1 Assume that the contract function is convex on [0, ) and zero at
the barrier. Then a down-and-out option has a positive if the interest rate is
dominated by the dividend rate and an up-and-out option has a negative if
the dividend rate is dominated by the interest rate.
Corollary 2 Super-hedging of up-and-out options and down-and-out options
by overestimating the volatility is possible in the cases described in Theorem 1
which give rise to convex prices.
2.1.2 Knock-in options
The pay-off of a knock-in option can be described by
(S(T))1
{
b
T}
,
and by risk-neutral valuation the value is given by
V(s, t) = E
s,t
e
r(Tt)
(S(T))1
{
b
T}
.
8
To price these options by the means of differential equations we view the
knock-in option as a knock-out contract paying zero at maturity if the barrier
is not hit and paying a rebate if the barrier b is hit. The rebate equals the
value of the corresponding vanilla option at b. More precisely, let f (s, t) =
E
s,t
e
r(Tt)
(S(T)). Then the rebate is given by f (b,
b
). Moreover, assuming
that the barrier is not yet hit at present time t, the function V(s, t) satises
Black-Scholes equation with boundary condition V(b, t) = f (b, t) and nal
value zero. By using the differential equation for V the following answers to
the questions posed in the beginning of this section can be given.
Theorem 2 (Convexity of knock-in options) Assume that the contract func-
tion is convex on [0, ). Then a down-and-in option has a positive if the
dividend rate is dominated by the interest rate and an up-and-in option has a
positive if the interest rate is dominated by the dividend rate.
Also in this case it can happen that if the relation between r and goes in
the wrong direction, a convex contract function need not give rise to a convex
price.
Corollary 3 Assume that the contract function is convex on [0, ). Then a
down-and-in option has a negative as long as the barrier has not been hit
if the dividend rate is dominated by the interest rate and an up-and-in option
has a positive as long as the barrier has not been hit if the interest rate is
dominated by the dividend rate.
Corollary 4 Super-hedging of up-and-in options and down-and-in options by
overestimating the volatility is possible in the cases described in Theorem 1
which give rise to convex prices.
2.2 Paper II
The main questions in Paper II are the following ones: For which class of
contract functions is it so that there exist a diffusion model in which the price
of an American option coincides with the price of the corresponding European
option? If we know that there is some diffusion model in which the prices
coincide, what can be said about the contract function?
It is well-known from the paper [11] that if the contract function is convex
and zero at the origin and if the dividend rate is zero, then the prices always
coincide. However, by relaxing the condition that the equality should hold
for all diffusion models, i.e. for all volatilities, but only demanding that the
equality holds for some non-zero volatility satisfying some suitable regular-
ity conditions, the class of contract functions becomes strictly larger than the
class of convex ones being zero at the origin. Moreover, if we know that there
is equality for some model, the contract function must belong to this class.
This means in particular that outside of this class there is no diffusion model
9
in which the prices can coincide, hence that the possibility to exercise early
always has a positive value.
The contract functions which qualies are the ones satisfying the following
conditions:
Condition 1 1. is piecewise C
2
on [0, ),
2.

+
(a)

(a) 0 for all a [0, )

Condition 2 1. s

(s) (s) 0 for all s 0, and

2. if s
0

(s
0
) (s
0
) > 0 for some s
0
> 0, then s

(s) (s) > 0 for all

s s
0
.
In the paper we assume that the stock-price solves an SDE of the form
dS(t) = rS(t)dt +S(t)(S(t), t)dW(t) for some Brownian motion W and that
the volatility satisfy the following conditions.
Assumption 1 1. The diffusion coefcient s(s, t) is strictly positive for all
s > 0 and all t [0, T].
2. There is a constant K > 0 such that |s(s, t)| K(1+s) for all s 0 and
all t [0, T].
3. The function s
2

2
(s, t) has a Hlder continuous partial derivative with
respect to s for every t [0, T] and is continuous in t.
The main result of the paper is the following one:
Theorem 3 Assume that the pay-off function is piecewise C
2
. Then satis-
es Conditions 1 and 2 if and only if there is a model such that the prices of
the European and American options with pay-off are the same.
2.3 Paper III
This paper deals with the size of the non-coincidence set of certain parabolic
obstacle problems. This is the set on which the solution to the obstacle prob-
lem is strictly larger than the obstacle. The operators in the paper have the
form
L f =
n

i, j=1
a
i j

2
f
x
i
x
j
+
n

i=1
b
i
f
x
i
+c f
f
t
.
We work under the assumption that the lower order coefcients are Dini-
continuous and that the top-order coefcients have Dini-continuous spatial
derivatives of rst order. Dini-continuity is weaker than the more common
Hlder continuity and is dened in the following way.
Denition 1 A modulus of continuity is called a Dini modulus of continuity
if

0
(s)
s
dt < for all > 0 small enough, and a function h is called Dini-
continuous if h has a Dini modulus of continuity.
10
The assumptions on the coefcients are the following.
Assumption 2 The coefcients a
i j
(x, t) are Dini-continuous in x and t and
have Dini-continuous rst-order partial derivatives with respect to x. The co-
efcients b
i
(x, t) and c(x, t) are all Dini-continuous in x and t.
The obstacle problem considered in this paper is the following one:

L f 0,
( f )L f = 0,
f ,
in some domain R
n
R, together with the initial condition f (x, 0) =
(x, 0), where is a C
2,1
-function with Dini-continuous partial derivatives.
The non-coincidence set is the set C = {(x, t) R
n
R : f (x, t) > (x, t)}
and the positivity set is dened as the set where is a strict sub-solution to
L f =0, i.e. the set U ={(x, t) R
n
R: L(x, t) >0}. The time-sections U
t
and C
t
are dened as U
t
={x R
n
: (x, t) U} and similarly for C
t
. It is clear
from the equation that the inclusion U C holds and the purpose of Paper III
is to show that if the boundary of U is smooth enough, then the inclusion is
strict. More precisely, the main result of Paper III is the following:
Theorem 4 Assume that the lateral part of the boundary of U can be repre-
sented locally by a surface which is C
1
-Dini is space and Lipschitz in time.
Then for each t > 0 there is (t) > 0, independent of x, such that the distance
between the boundaries of the time-sections U
t
and C
t
is greater than (t).
The main tool in showing Theorem 4 is the Hopf boundary point lemma,
which states that a positive supersolution, to a parabolic equation, which van-
ishes at a point on the boundary of a domain must have a positive inward
directional derivative at the same point. However, in the standard literature,
e.g. [12] or [18], one assumes that the boundary has a strong interior sphere
property (at least in the spatial variables) which essentially means that one
should be able to touch the boundary from the inside of the domain with a
sphere. But by using the C
1
-Dini assumption on the top-order coefcient and
Theorem 1.5.10 in [4] and a change of variables, a Hopf-type lemma can be
obtained for domains satisfying only the interior C
1
-Dini condition in Theo-
rem 4.
The results of Theorem 4 can be used to show that the boundary of the pos-
itivity set cannot touch the boundary of the continuation region in American
option pricing and that it must lie on a uniform distance in space from the free
boundary.
11
2.4 Paper IV
The nal paper is a paper in which explicit pricing formulas are derived for
turbo warrants of put and call types in the classical Black-Scholes model. In
this paper the stock-price process is assumed to evolve according to
S(t) = S(0)e
(r
1
2

2
)t+W(t)
for some Brownian motion W. Given a barrier b > 0 and a strike price K < b,
a turbo call pays
(S(T) K)
at maturity T if the underlying stock stays above the barrier b at all times
before maturity. If the barrier is hit, say at
b
, then a rebate
(m(
b
+) K)
+
is paid at time
b
+, i.e. time units after the rst time S hits b.
The pay-off of a turbo put is dened in an analogous way. In this case K >b
and the pay-off at maturity T is
(KS(T))
if the stock-price stays below the barrier at all times before maturity. If the
barrier is hit at some time
b
prior to maturity a rebate
(KM(
b
+))
+
is paid at
b
+. Here m(t) =min
0ut
S(t) and M(t) =max
0ut
S(t) denotes
the running minimum and the running maximum respectively.
To price the warrant one prices the two parts separately, i.e. the knock-out
part and the rebate part. The key observation to make here is that the rebate
part can be viewed in the following way. Consider rst the call-case:
Let V
c
(b) = E
b
e
r
(m() K)
+
, i.e. the value of the rebate when the bar-
rier is hit.
The rebate has the same value as an American digital option paying V
c
(b)
at the rst hitting time
b
given that the stock-price is above, and has not
hit the barrier yet. The value is given by V
c
(b)E
s,t
e
r(
b
t)
1
{
b
T}
.
The put-case is similar:
Let V
p
(b) = E
b
e
r
(KM())
+
.
The rebate has the same value as an American digital option paying V
p
(b)
at the rst hitting time
b
given that the stock-price is below and has not hit
the barrier yet. The value is given by V
p
(b)E
s,t
e
r(
b
t)
1
{
b
T}
Now since the densities for
b
, m(t) and M(t) are explicitly known, the prob-
lem of nding the price is just a matter of integration. Notice that the de-
composition made above strongly depends on the time-homogeneity and the
Markov property of the underlying process S(t). With a time-inhomogeneous
process the decomposition is no longer possible and we really need the joint
density of (m(t),
b
) and the joint density of (M(t),
b
).
12
Sammanfattning p svenska (Summary in
Swedish)
I denna avhandling bestende av en introduktion och fyra artiklar studeras
nansiell matematik i kontinuerlig tid. Huvudtemat fr avhandlingen r
vgberoende optioner och de optioner som studeras r barriroptioner och
amerikanska optioner. I nansiell matematik r man ofta intresserad av att
prisstta nansiella instrument denierade i termer av ngon underliggande
tillgng ssom en aktie. I och med att den underliggande tillgngens framtida
vrde i allmnhet inte r knt s modelleras den med en stokastisk process.
I denna avhandling anvnds lsningar till stokastiska differentialekvationer
som modell fr aktiepriset.
Priset fr en option kan i allmnhet berknas som ett vntevrde
av en kontraktsfunktion av den underliggande stokastiska processen.
Kontraktsfunktionen r en p frhand specicerad funktion som anger
hur utbetalningsstrukturen fr kontraktet ser ut. I och med den vlknda
kopplingen mellan paraboliska partiella differentialekvationer och ovan
nmnda vntevrde kan optionspriset ven berknas som lsningen till en
differentialekvation inte helt olik vrmeledningsekvationen.
En stor skillnad mellan nansiella och fysikaliska problem r att aktiens
framtida volatititet (motsvarar diffusionskoefcienten i fysikaliska problem)
i allmnhet r oknd. Man fr frlita sig p historiska data eller intelligenta
gissningar och en viktig frga i nansiella tillmpningar r drfr hur op-
tionspriset beror p volatiliteten och hur en felspecicerad volatilitet pverkar
priset. I papper I undersks denna frga fr barriroptioner av europeisk typ.
En barriroption r en option med en extra klausul som sger att optionen fr-
faller vrdels om en p frhand given barrir ns av aktiepriset ngon gng
fre slutdatumet fr optionen. Det visar sig att liksom i fallet med vanliga eu-
ropeiska och amerikanska optioner r konvexitet hos optionpriset i aktiepriset
avgrande fr hur optionspriset beror p volatiliteten. Om optionspriset r
konvext r det ocks vxande i volatiliteten. Konvexitet hos barriroptioner
studeras i detta papper med hjlp av paraboliska differentialekvationer och
det visas att om kontraktsfunktionen r konvex och noll i barriren och om
den riskfria rntan och utdelningstakten frhller sig till varandra p ett visst
stt s r barriroptionspriset konvext i aktiepriset.
I papper IV studeras en annan typ av barriroption, en s kallad turbowar-
rant. Detta r ett relativt nytt instrument och skillnaden mot vanliga barrirop-
tioner r att optionsinnehavaren har mjlighet att f en liten summa pengar
13
ven om den underliggande tillgngen slr i barriren innan mognadsdatumet.
Denna summa beror p det lgsta eller det hgsta aktiepriset under en kort
period efter det att barriren slagits i (typiskt 3 timmar) beroende p om det
r en warrant av kp- eller sljtyp. Syftet med papperet r att hrleda explicita
prisformler fr turbowarranter nr den underliggande aktien antas flja en ge-
ometrisk Brownsk rrelse som r fallet i Black och Scholes klassiska modell.
En annan typ av vgberoende option r den s kallade amerikanska optio-
nen. En amerikansk option kan till skillnad mot en europeisk option lsas in
nr som helst innan mognadsdatumet. Frutom att bestmma priset av optio-
nen r det hr ocks intressant att bestmma en optimal strategi, dvs bestmma
nr optionen skall lsas in s att detta grs p ett optimalt stt. P grund av
att optionen kan lsas in nr som helst kommer vrdet alltid att ligga ovanfr
kontraktsfunktionen. Intuitivt r det klart att om optionsvrdet r strikt strre
n kontraktsfunktionen s skall optionen behllas. Klassiska resultat sger att
en optimal tidpunkt att lsa in optionen r frsta gngen optionsvrdet r lika
med kontraktsfunktionens vrde. Omrdet dr optionen skall behllas kallas
fr fortsttningsomrdet och spelar en avgrande roll i bestmmandet av op-
timala strategier. I allmnhet r detta omrdet mycket svrt eller omjligt att
bestmma explicit. Det r drfr intressant att f kvalitativ information om hur
det ser ut och hur stort det r.
I papper II studeras under vilka frutsttningar somdet amerikanska option-
spriset sammanfaller med motsvarande europeiska pris. Knda resultat sen
tidigare ger att om kontraktsfunktionen r konvex och noll i origo s sam-
manfaller priserna i alla diffusionsmodeller. I papper II studeras vilka kon-
traktsfunktioner som har den egenskapen att det nns ngon modell i vilken
priserna sammanfaller. Det visar sig att denna klass av funktioner innehller
funktioner som ej r konvexa. Det visar sig ocks att om det r s att priserna
sammanfaller i ngon modell s mste kontraktsfuntionen komma frn denna
klass. Speciellt betyder detta att utanfr denna klass av funktioner r alltid en
amerikansk option vrd mer n en europeisk.
I papper III studeras storleken p fortsttningsomrdet fr amerikanska op-
tioner i fallet med mnga underliggande tillgngar. Precis som fr europeiska
optioner kan priset av en amerikansk option beskrivas med hjlp av lsnin-
gen till en parabolisk differentialekvation. Mjligheten att lsa in optionen
nr som helst gr dock att randen till omrdet dr ekvationen skall lsas r
oknd och mste bestmmas som en del av lsningen. Priset uppfyller ett s
kallat fritt randproblem. Detta kan skrivas om till en variationsolikhet som i
sin tur r ett hinderproblem. I papper III visas att det omrden som utgrs av
de punkter i vilka kontraktsfunktionen (dvs hindret) r en strikt sublsning
till Black-Scholes ekvation, kallat positivitetsomrdet, r en kta delmngd
av fortsttningsomrdet och att fr en given tidpunkt nns ett minsta avstnd
mellan dessa tv mngder som kan vljas lika fr alla vrden p aktiepriset.
14
Acknowledgments
I am most grateful and indebted to my adviser Johan Tysk for his guidance,
his support and for sharing his deep mathematical knowledge and insight with
me. His pushing me forward has been invaluable to me and to the process of
writing this thesis. His comments on the manuscripts have greatly improved
the work.
I would also like to thank FMB (the Graduate School in Mathematics and
Computing) for nancial support, my colleagues at the Department of Mathe-
matics, my friends and family, and last but not least Salla for always believing
in me and bearing with me during these ve years.
15
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18