Pricing discretely-monitored double barrier options with small probabilities of execution

Vasileios E. Kontosakos, Keegan Mendonca, Athanasios A. Pantelous, Konstantin M. Zuev

Research output: Contribution to journalArticleResearchpeer-review

Abstract

In this paper, we propose a new stochastic simulation-based methodology for pricing discretely-monitored double barrier options and estimating the corresponding probabilities of execution. We develop our framework by employing a versatile tool for the estimation of rare event probabilities known as subset simulation algorithm. In this regard, considering plausible dynamics for the price evolution of the underlying asset, we are able to compare and demonstrate clearly that our treatment always outperforms the standard Monte Carlo approach and becomes substantially more efficient (measured in terms of the sample coefficient of variation) when the underlying asset has high volatility and the barriers are set close to the spot price of the underlying asset. In addition, we test and report that our approach performs better when it is compared to the multilevel Monte Carlo method for special cases of barrier options and underlying assets that make the pricing problem a rare event estimation. These theoretical findings are confirmed by numerous simulation results.

Original languageEnglish
Number of pages18
JournalEuropean Journal of Operational Research
DOIs
Publication statusAccepted/In press - 2020

Keywords

  • Simulation
  • Barrier options pricing
  • Rare event
  • Path–dependent derivatives
  • Discrete monitoring

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