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Static replication of barrier-type options via integral equations

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  • Kyoung-Kuk Kim
  • Dong-Young Lim

Abstract

This study provides a systematic and unified approach for constructing exact and static replications for exotic options, using the theory of integral equations. In particular, we focus on barrier-type options including standard, double and sequential barriers. Our primary approach to static option replication is the DEK method proposed by [Derman, E., Ergener, D. and Kani, I., Static options replication. J. Derivat., 1994, 2, 78–95]. However, our solution approach is novel in the sense that we study its continuous-time version using integral equations. We prove the existence and uniqueness of hedge weights under certain conditions. Further, if the underlying dynamics are time-homogeneous, then hedge weights can be explicitly found via Laplace transforms. Based on our framework, we propose an improved version of the DEK method. This method is applicable under general Markovian diffusion with killing.

Suggested Citation

  • Kyoung-Kuk Kim & Dong-Young Lim, 2021. "Static replication of barrier-type options via integral equations," Quantitative Finance, Taylor & Francis Journals, vol. 21(2), pages 281-294, February.
    • Handle: RePEc:taf:quantf:v:21:y:2021:i:2:p:281-294
    DOI: 10.1080/14697688.2020.1817973
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    Cited by:

    1. Samuel N. Cohen & Christoph Reisinger & Sheng Wang, 2022. "Hedging option books using neural-SDE market models," Papers 2205.15991, arXiv.org.
    2. Ma, Jingtang & Yang, Wensheng & Cui, Zhenyu, 2021. "CTMC integral equation method for American options under stochastic local volatility models," Journal of Economic Dynamics and Control, Elsevier, vol. 128(C).

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