Guaranteed deterministic approach to superhedging: case of binary European option (Q2664861)

Summary: For the superreplication problem with discrete time, a guaranteed deterministic formulation is considered: the problem is to guarantee coverage of the contingent liability on sold option under all admissible scenarios. These scenarios are defined by means of a priori defined compacts dependent on price prehistory: the price increments at each point in time must lie in the corresponding compacts. In a general case, we consider a market with trading constraints and assume the absence of transaction costs. The formulation of the problem is game theoretic and leads to the Bellman-Isaacs equations. This paper analyses the solution to these equations for a specific pricing problem, i.e., for a binary option of the European type, within a multiplicative market model, with no trading constraints. A number of solution properties and an algorithm for the numerical solution of the Bellman equations are derived. The interest in this problem, from a mathematical prospective, is related to the discontinuity of the option payoff function.