Finance Stochast.

4, 105107 (2000)

c Springer-Verlag 2000

Comment on Pricing double barrier options using Laplace transforms by Antoon Pelsser
C.H. Hui1 , C.F. Lo2 , P.H. Yuen2
1

Banking Policy Department, Hong Kong Monetary Authority, 30/F, 3 Garden Road, Central, Hong Kong, China (e-mail: cho-hoi hui@hkma.gov.hk) 2 Department of Physics, The Chinese University of Hong Kong, Shatin, New Territories, Hong Kong, China (e-mail: co@phy.cuhk.edu.hk)

Abstract. In this paper we comment on the paper Pricing Double Barrier Options using Laplace Transforms by Antoon Pelsser. We illustrate that the same solutions of double barrier option values in terms of Fourier sine series can be obtained by using both Laplace transform and the method of separation of variables. The solutions in terms of the cumulative normal distribution function can be derived by employing the method of reection. Furthermore, we discuss the numerical characteristics of the pricing solutions. Key words: Barrier options, Black and Scholes model, partial differential equations JEL classication: G13 Mathematics Subject Classication (1991): 30K05, 35K15, 35K20 Pelssers paper acknowledges that the same results can be derived by other methods. The method of separation of variables has been employed by Hui (1996) to solve double barrier option values. The same option values of constant payoff at maturity and rebate at hit presented in Pelssers paper are obtained by solving the Black-Scholes partial differential equation (Black and Scholes 1973) with the corresponding boundary conditions. The solutions are presented in terms of Fourier sine series which form the eigenfunctions of the Black-Scholes equation. Valuation of double knock-out options using the separation of variables method has been discussed in Hui (1997). Obtaining the same solutions of all these option values by using the two different methods is reected from the density function g (x , t ) of hitting the barrier in Eq.(6) of the paper, which is a Fourier series
This work is partially supported by the Direct Grant for Research from the Research Grants Council of the Hong Kong Government. The conclusions herein do not represent the views of the Hong Kong Monetary Authority. Manuscript received: March 1999; nal version received: July 1999

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representation. It is also noted that the value of the knock-in option presented in Sect. 3.4 of the paper can be obtained by replicating the option by buying an ordinary call, selling a double knock-out call plus the value of a rebate at hit option with a rebate {L K exp[(rd rf )t ]} at the lower barrier L. All the options have the same barriers and strike K . The replication applies put-call parity such that only a put option exists when the lower barrier is hit. In addition to the above methods, the double barrier options can also be priced by solving the Black-Scholes equation using the Greens function approach. The Black-Scholes equation is rst transformed into a standard diffusion equation (heat equation) as suggested by Wilmott et al. (1993). The Greens function G which is then constructed by the method of reection (John, pp.220-221) is written as

G (x , x , t t ) =
n =

F (x x + 2nl , t t ) F (x + x 2nl , t t )

(1)

where F (x , t ) = x2 1 exp 4t 4 t

is the well-known Gaussian heat kernel satisfying the diffusion equation and l is the width of the double barrier. The double barrier option values can be obtained by applying the Greens function and the nal payoff condition u (x , 0) to solve the diffusion equation and is expressed as
l

u (x , t ) =
0

u (x , 0)G (x , x , t )dx

(2)

The pricing formula (2) can be rewritten as the sum of an innite series of a cumulative normal distribution function N (x ) and the result is the same as the double barrier options pricing formula solved by using the probabilistic approach presented in Kunitomo and Ikeda (1992). Therefore, the values of double barrier options of constant payoff at maturity and rebate at hit obtained by both approaches can also be expressed in terms of N (x ). Simple numerical tests suggest that the convergence of both series of Fourier sine and N (x ) is rapid. However, the convergence and accuracy of the solutions have not been tested under some extreme conditions such as the underlying asset price near barriers, long/short maturity and high/low volatility. Errors in numerical implementation may also occur due to the numerical characteristics of the series or limitations of computers capability. Thus, it is important to understand how robust the series solutions are when they are implemented in a trading system to calculate option prices and hedge parameters. In the Fourier sine series, the factor exp(x / 2 ) with negative and small volatility makes initial terms of the series absolutely large and the solution takes many terms to converge. Low volatility can occur in currencies with linked exchange rates and target zones. In addition, adding very large positive and

Comment on Pricing double barrier options using Laplace transforms

107

2.00

1.50

1.00

0.50

0.00 0 0.05 0.1 112 -0.50 110

Time to Maturity t

0.15 0.2 124 0.25 122 120 118

116

114

Underlying Price S

Fig. 1. Illustration of option values with large truncation error (L = 110, H = 125, rf = 0.1, rd = 0.01, = 0.02)

negative terms causes truncation errors due to nite precision of computers (say, a double precision provides 16 decimal places). The situation is worsen with short-dated options ( 1 day maturity) and wide barriers which make the terms decay less effectively. This observation is illustrated in Fig. 1 using a constant payoff at maturity option with payoff 1, lower barrier L = 110, upper barrier H = 125, rf = 0.1, rd = 0.01, and = 0.02. The wrong option values near the lower barrier are due to truncation errors (not the Gibbs phenomenon) that could not be eliminated by computational technique or by summing more terms in the series. On the other hand, in the N (x ) series, negative and small volatility make the argument of N (x ) be negatively large and thus N (x ) be small. This cancels the effect from the factor exp(x / 2 ) in the solution. Moreover, solution (2) indicates that the convergence of the series is faster with small t and large l , which make the Gaussian factor decay fast. In view of the N (x ) series having better numerical characteristics than the Fourier sine series, it is more appropriate to implement the N (x ) series expression in a trading system, even spending more computational time in some cases such as large t and small l . References
Black, F., Scholes, M.: The pricing of options and corporate liability. J. Pol. Econ. 8, 637654 (1973) Hui, C. H.: One-touch double barrier binary option values. Appl. Financial Econ. 6, 343346 (1996) Hui, C. H.: Time dependent barrier option values. J. Futures Markets 17, 667688 (1997) John, F.: Partial differential equations. New York: Springer 1982 Kunitomo, N., Ikeda, M.: Pricing options with curved boundaries. Math. Finance 2, 275298 (1992) Wilmott, P., Dewynne, J., Howison, S.: Option pricing: Mathematical models and computation. Oxford: Oxford Financial Press 1993

Option Value f