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Replication Methods in the Pricing and Hedging of Barrier Options

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  • Tichý Tomáš

Abstract

This paper considers various options replication methods. Firstly, a specific type of barrier option, an up-and-out call, is considered. Other barrier options are briefly also described, and various types of barriers are considered. Secondly, a general definition of replication methods is provided. Two methods are thus examined in detail: The first one, based on ever-changing positions in replicating portfolio, is referred to as a dynamic replication method. The second one is denoted as a static replication method ? its aim is to create a static basket of simple assets that will replicate the option payoff. However, in the real world it is difficult to attain perfect replication; therefore, the expected replication error of both methods is studied via simulation technique.

Suggested Citation

  • Tichý Tomáš, 2004. "Replication Methods in the Pricing and Hedging of Barrier Options," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 54(7-8), pages 305-324, July.
  • Handle: RePEc:fau:fauart:v:54:y:2004:i:7-8:p:305-324
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    References listed on IDEAS

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    More about this item

    Keywords

    Options; barrier options; replication methods; dynamic and static replication; replication error;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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