Valuation of exotic options under shortselling constraints (Q1849790)

This article deals with the valuation of options with discontinuous payoffs. The authors use a method based on the idea of super-replication. The price of a contingent claim obtained by this method is called the upper hedging price. Let \((\Omega,{\mathcal F}(T),P)\) be a canonical probability space for a Brownian motion \(W(t)\), and let \(F(t), 0\leq t\leq T\) be the corresponding filtration. Let us denote by \(\Lambda=\{\lambda: \lambda\) is an \(\{F(t),0\leq t\leq T\}\)-adapted, nondecreasing, continuous process with \(\lambda(0)=0\}\). The following result is proved. Let \(g\) be a nonnegative lower semicontinuous function defined on \(C_{+}[0,T]\) - the space of nonnegative continuous functions on \([0,T]\). The upper hedging price for the contingent claim with payoff \(g(S)\) at the expiration date \(T\) and hedge-portfolio constraint \(\pi(t)\geq -\alpha, 0\leq t\leq T, \alpha\in [0,\infty)\) a.s. is \(v(0, S(0);\alpha)=\sup_{\lambda\in\Lambda} E\left[e^{-rT- \alpha\lambda(T)}g(Se^{-\lambda})\right]\), where \(S=\{S(t)= S(0)\exp\{\sigma W(t)+rt-\sigma^2 t/2\}, 0\leq t\leq T\}\). An application of this result for valuation of the knock-out call option is presented as well as an extension of the obtained result for the knock-out options with discrete checking of barriers. As examples the cactus option, digital put, discrete barrier option, vanilla put, lookback put, Asian put, book of two barrier options are considered.