Watermark options (Q503393)

The authors consider a new class of derivatives the payoffs of which depend on asset price falls relative to their underlying asset's historical maximum price. This new class of derivatives is called ``watermark'' options. The complete solution to the optimal stopping problems associated with the pricing of the perpetual American versions of the ``watermark'' options is presented. In particular, the free-boundary functions that provide the optimal stopping times for the mentioned optimal stopping problems are studied and characterized as the unique solutions to highly nonlinear first-order ordinary differential equations that have the characterstics of a separatrix. The asymptotic growth of free-boundary functions is investigated.