Local time, coupling and the passport option (Q1979077)

This article is concerned with the pricing and hedging of a new type of contingent claim, called a passport option. It is fundamentally different from most existing claims in that the underlying asset is a trading account. The buyer of the passport option pays a premium upfront and trades according to a strategy of their choice. This strategy is unrestricted except that the number of units of the risky asset held, long or short, is bounded. At the expire date \(T,\) either the gains from this strategy are paid to the holder, or if the account lost money, the loss is borne by the seller giving the buyer a zero net position. A simplified form for the price of the passport option using local time is derived. A key is that Tanaka's formula and the Skorokhod lemma allow to prove a direct relationship between the prices of passport and look back options. Explicit calculations are provided in the case where the underlying is an exponential Brownian motion. The further contribution of this article is to extend existing results on the form of the optimal strategy from exponential Brownian motion model to a wide class of alternative price processes. This is achieved by using coupling arguments.