Options on a traded account: Vacation calls, vacation puts and passport options (Q5926467)

An option on a traded account is a contract which allows the holder of the option to switch during the life of the option among various positions in an underlying asset. In this paper, the holder's trading is financed by investing or borrowing at the interest rate \(r.\) The holder accumulates gains and losses resulting from this trading, and at the expiration of the option he gets the call option payoff with strike \(0\) on his final account value, i.e., he keeps any gain from trading and is forgiven any loss. Dynamic of the asset price is described by linear stochastic differential equation with interest rate \(r\) and volatility \(\sigma.\) Denote the option holder's trading strategy by \(q_{t},\) the number shares held at time \(t.\) The strategy \(q_{t}\) must satisfy the contractual constraint \(q_{t}\in [\alpha,\beta],\) where \(\alpha\leq\beta.\) It turns out that the holder of the option should never take an intermediate position, i.e., at any time he should hold either \(\alpha\) shares of stock or \(\beta\) shares. When \(\alpha=\beta=1,\) the option shall be seen to reduce to a European call; when \(\alpha=\beta=-1,\) it reduces to a European put. When \(\alpha=-1\) and \(\beta=1,\) then it is a passport option. So that at any time the option holder should be either long or short one share of stock. There are many possible variations on the passport option, one of them being the constraint \(\alpha\leq q_{t} \leq \beta.\) This variation is the subject of the present paper. The passport option is a special case and the authors also single out the special case they call the vacation call option corresponding to \(0\leq q_{t}\leq 1\) and the vacation put option corresponding to \(-1\leq q_{t}\leq 0.\) These shall be seen to generalize the American call and the American put. The authors establish a ``put-call parity'' formula relating these options. Using probabilistic techniques, the authors find the value of these options, the optimal strategy of the buyer, and the hedging strategy the seller should use in response to a (not necessarily optimal) strategy by the buyer.