Barrier options and touch-and-out options under regular Lévy processes of exponential type (Q1872362): Difference between revisions

Various aspects of pricing of barrier options and touch-and-out options have been considered in a number of papers and books in financial mathematics, where only Gaussian processes have been allowed. In this paper, the authors consider the case when the returns \(X_t=\ln S_t\) on the stock \(S_t\) follow a Lévy process from a wide class of processes under the name ``regular Lévy processes of exponential type'' (RLPE). It means that generators of these processes enjoy very favorable features from the point of view of the theory of pseudo-differential operators and tails of PDF are exponentially decaying. Assuming that the riskless rate \(r>0\) is constant, and an equivalent martingale measure \(Q\) is chosen so that, under \(Q,\) \(X\) is an RLPE, the authors derive explicit formulas for the prices of barrier options on the stock with one fixed barrier and touch-and-out options. By using the Dynkin formula, the optimal stopping problem is reduced to a free boundary problem; to solve the latter, the Wiener-Hopf factorization is used. Hence, the pricing formulas are expressed in terms of the factors in the Wiener-Hopf factorization formula.