The Evaluation of Barrier Option Prices Under Stochastic

Volatility

Carl Chiarella†, Boda Kang† and Gunter H. Meyer?

†
School of Finance and Economics
University of Technology, Sydney
?
School of Mathematics
Georgia Institute of Technology, Atlanta.

BFS 2010
Hilton, Toronto
June 24, 2010
Plan of Talk

• Barrier Options: Discretely and Continously monitored

• PDE setup for Barrier option prices under Heston Model

• Allow for early exercise

• Method of Lines Approach

• Numerical Examples

• Conclusion

Chiarella, Kang and Meyer BFS 2010 1

1 Barrier Option
• Path-dependent options, very popular in foreign exchange markets. The
purchaser uses them to hedge very specific cash flows with similar prop-
erties but pays a cheaper price than regular options.
• Payoff is dependent on the realized asset path via its level. See Figure 1
for up-and-out call option payoff.
• Apart from “out” options, there are also “in” options which only receive
a payoff if a certain level is reached, otherwise they expire worthless.
• In-Out-Parity for Barrier options: Knock-in + Knock-out = Vanilla.
• Put-Call-Symmetry for Barrier Options: Up-and-out Call(S, K, H, r, q, ρ) =
Down-and-out Put(K, S, SK/H, q, r, −ρ).
• We consider up-and-out call options in the following.

Chiarella, Kang and Meyer BFS 2010 2

 Up and out Call
145

140
Payoff = 0 (European)
or
135 Payoff = H−K (American)

130

125
Payoff = max(S−K,0)

120
S

115

110

105

100

95

90
t

Figure 1: Diagram: Payoff of an up and out call options.

Chiarella, Kang and Meyer BFS 2010 3
2 Literature Review
• Merton (1973): the derivation of the pricing formula for barrier options;
• Rich (1994) and Wong & Kwok (2003): a list of pricing formulas for
one and multi-asset barrier options both under the GBM framework;
• Gao, Huang & Subrahmanyam (2000): option contracts under GBM
with both knock-out barrier and American early exercise features;
• Zvan, Vetzal & Forsyth (2000): discuss the oscillatory behavior of the
Crank - Nicolson method for pricing barrier options. The backward Eu-
ler method is applied to avoid unwanted oscillations;
• Griebsch (2008): discusses evaluation of barrier option prices under the
Heston model with Fourier transform approach;
• Yousuf (2008, 2009): develops a higher order smoothing scheme for
pricing barrier options under SV without early exercise.

Chiarella, Kang and Meyer BFS 2010 4

3 Barrier Options - Evaluation under SV

• We follow Heston (1993) assuming the dynamics for S under RN mea-

sure governed by
√
dS = (r − q)Sdt + vSdZ1 ,
√
dv = (κv θv − (κv + λ)v)dt + σ vdZ2 .

• Here S and v are correlated with E(dZ1 dZ2 ) = ρdt.

√
• Assumes market price of vol. risk = λ v.

Chiarella, Kang and Meyer BFS 2010 5

 • The price of a barrier option C(S, v, τ ) at time to maturity τ is the
solution to a partial differential equation (PDE) problem.

• We need to solve the PDE

∂C
= KC − rC,
∂τ
on the interval 0 ≤ τ ≤ T , where the Kolmogorov operator K
vS 2 ∂ 2 ∂2 σ2 v ∂ 2 ∂
K = + ρσvS + + (r − q) S +
2 ∂S 2 ∂S∂v 2 ∂v 2 ∂S
∂
(κv (θv − v) − λv) .
∂v

Chiarella, Kang and Meyer BFS 2010 6

3.1 Continuously monitored barrier options

• Continuously monitored barrier option C(S, v, τ ): an option which is

monitored all the time between the current time t and the maturity of the
option at time T . Note that τ = T − t.
• The option, has the terminal condition

C(S, v, 0) = (S − K)+ .

• The domain for the up and out call option is

0 ≤ S ≤ H, 0 < v < ∞, 0 ≤ τ ≤ T .

• The boundary conditions for the barrier option without the early exercise
features are:

C(0, v, τ ) = 0; C(H, v, τ ) = 0; lim Cv (S, v, τ ) = 0.

v→∞

Chiarella, Kang and Meyer BFS 2010 7

 • The option with early exercise features has the free boundary condition

C(b(v, τ ), v, τ ) = b(v, τ ) − K, when b(v, τ ) < H

where S = b(v, τ ) is the early exercise boundary for the barrier option
at time to maturity τ and variance v.
• There also hold the smooth-pasting conditions
∂C ∂C
lim = 1, lim = 0.
S→b(v,τ ) ∂S S→b(v,τ ) ∂v
• In the above case,

C(S, v, τ ) = S − K, ∀ b(v, τ ) < S < H.

• However, if we cannot find a b(v, τ ) < H then

C(H, v, τ ) = H − K.

Chiarella, Kang and Meyer BFS 2010 8

 • Technically, for the knock-out event and the exercise date to be well
defined,
− the option contract is defined in a way such that when the asset price first
touches the barrier, the option holder has the option to either exercise or
let the option be knocked out.

• Since in this paper we assume the rebate is equal to zero, the option
should be exercised once the asset price touches the barrier.

Chiarella, Kang and Meyer BFS 2010 9

3.2 Discretely monitored barrier options

• A discretely monitored barrier option is an option which is monitored

only at discrete dates t ≤ t1 < t2 < · · · < tN ≤ T .
• The option has the terminal condition

C(S, v, 0) = (S − K)+ .

• The domain for the up and out call option is:

(0, H), τ ∈ {T − tN , T − tN −1 , · · · , T − t1 },

S∈
(0, ∞), otherwise,

and
0 < v < ∞, 0 < τ < T .

Chiarella, Kang and Meyer BFS 2010 10

 • The boundary conditions for the barrier option without early exercise
features are:

C(0, v, τ ) = 0;
C(H, v, τ ) = 0, ∀τ ∈ {T − tN , · · · , T − t1 };
lim C(S, v, τ ) = 0, ∀τ ∈
/ {T − tN , · · · , T − t1 };
S→∞
lim Cv (S, v, τ ) = 0.
v→∞

• A discretely monitored barrier option with the early exercise feature, at

the monitoring times τ ∈ {T − tN , · · · , T − t1 }, has the free (early
exercise) boundary condition

C(b(v, τ ), v, τ ) = b(v, τ ) − K, when b(v, τ ) < H.

Chiarella, Kang and Meyer BFS 2010 11

 • Here b(v, τ ) is the early exercise boundary for the barrier option at time
to maturity τ and variance v, and satisfies the smooth-pasting conditions
∂C ∂C
lim = 1, lim = 0.
S→b(v,τ ) ∂S S→b(v,τ ) ∂v
• In the above case, we have

C(S, v, τ ) = S − K, ∀ b(v, τ ) < S < H

so that C(S, v, τ ) is known over 0 < S < H.

• If there is no such b(v, τ ) then for the same reason as the case for the
continuously monitored option, C(S, v, τ ) must satisfy

C(H, v, τ ) = H − K.

• At all other times τ ∈

/ {T − tN , · · · , T − t1 }, standard American
option free boundary conditions apply.

Chiarella, Kang and Meyer BFS 2010 12

4 Method of Lines (MOL) Approach

• The method of lines has several strengths when dealing with Barrier
options, especially when allowing early exercise features:
− The price, free boundary, delta and gamma are all found as part of
the computation.
− The method discretises the PDE in an intuitive manner, and is readily
adapted to be second order accurate in time.

• The key idea behind the method of lines is to replace a PDE with an
equivalent system of one-dimensional ODEs.
• The system of ODEs is developed by discretising the time derivative
and the derivative terms involving the variance, v.

Chiarella, Kang and Meyer BFS 2010 13

 • The PDE to be solved is
∂C vS 2 ∂ 2 C ∂2C σ2 v ∂ 2 C
= + ρσvS +
∂τ 2 ∂S 2 ∂S∂v 2 ∂v 2
∂C ∂C
+ (r − q)S + (κv (θv − v) − λv) .
∂S ∂v
• The computational domain for the problem will depend on the specific
Barrier option, for example,
− for a continuously monitored up and out call option, we would have:

0 < S0 < S < H, 0 < v < ∞, 0 < τ < T .

Chiarella, Kang and Meyer BFS 2010 14

 • We discretise according to τn = n∆τ and vm = m∆v, where n =
1, . . . , N ; m = 1, . . . , M.
n
• C(S, vm , τn ) = Cm (S),
∂C(S, vm , τn ) n
V (S, vm , τn ) ≡ = Vm (S).
∂S
• We use the standard central difference scheme
n n n n n
∂2C Cm+1 − 2Cm + Cm−1 ∂2C Vm+1 − Vm−1
2
= 2
, = .
∂v (∆v) ∂S∂v 2∆v
• We use an upwinding finite difference scheme for the first order deriva-
tive term
 n n
Cm+1 −Cm α
∂C 
∆v
if v ≤ β
,
= C n
−C n
∂v  m m−1
if v > α .
∆v β

Chiarella, Kang and Meyer BFS 2010 15

 • A second order approximation for the time derivative,
n n−1 n−1 n−2
∂C 3 Cm − Cm 1 Cm − Cm
= + .
∂τ 2 ∆τ 2 ∆τ
• After taking the boundary conditions into consideration, we must solve
a system of (M − 1) second order ODEs in S along the line segment
(vm , τn ), S ∈ [S0 , H] or S ∈ [S0 , Smax ] depending on the prop-
erties of the barrier option for m = 1, .., M − 1 and fixed τn .
• We then solve the ODEs for increasing values of v, using the latest avail-
n n n n
able estimates for Cm+1 , Cm−1 , Vm+1 and Vm−1 .

• We iterate until the price profile converges to a desired level of accuracy.

Chiarella, Kang and Meyer BFS 2010 16

 v Boundary condition (v = vM )

Initial
Condition
(Payoff)

τ
Boundary condition v = 0

Figure 2: One sweep of the solution scheme on the v − τ grid. The stencil
for the typical point o is displayed in Figure 3.
Chiarella, Kang and Meyer BFS 2010 17
 n
b
C m+1

n−1
n−2 Cm
Cm b n
b o Cm

b n
Cm−1

Figure 3: Stencil for the typical grid point o of Figure 2. The stencil for
n n n n n−1 n−2
Cm depends on (Cm−1 , Cm , Cm+1 , Cm , Cm ).
Chiarella, Kang and Meyer BFS 2010 18
 • The generic first order form of the ODE
n
dCm n
Delta = Vm ,
dS
n
dVm n n n
Gamma = Am (S)Cm + Bm (S)Vm + Pm (S),
dS
n n n n n
where Pm (S) is also a function of Cm+1 , Cm−1 , Vm+1 , Vm−1 ,
n−1 n−2
Cm , Cm .
• We solve the above system using the Riccati transform.

• The Riccati transformation

n n n
Cm (S) = Rm (S)Vm (S) + Wm (S).

Chiarella, Kang and Meyer BFS 2010 19

 • Where R and W are solutions to the initial value problems
dRm
= 1 − Bm (S)Rm − Am (S)(Rm )2 , Rm (S0 ) = 0,
dS
n
dWm n n n
= −Am (S)Rm (S)Wm − Rm (S)Pm (S), Wm (S0 ) = 0.
dS
n
• Given R and W we try to find Vm by solving
n
dVm n n n n
= Am (S)(Rm (S)Vm + Wm (S)) + Bm (S)Vm + Pm (S),
dS
backward subject to an terminal condition which depends on the prop-
erties and the specifications of the barrier options.

Chiarella, Kang and Meyer BFS 2010 20

 Figure 4: Solving for the option prices along a (vm , τn ) line.

Chiarella, Kang and Meyer BFS 2010 21

 • Continuously monitored barrier options without early exercise oppor-
n
tunities, using the fact that Cm (H) = 0 we obtain from the Riccati
transform that the terminal condition is
n
n Wm (H)
Vm (H) = − ,
Rm (H)
n
and then integrate the equation for Vm from S = H to S = S0 .
• Continuously monitored barrier option with early exercise opportunity
n
we integrate the equation for Wm and Rm from S0 to Smax and mon-
itor the function
n
φ(S) = Rm (S) + Wm (S) − (S − K).

Chiarella, Kang and Meyer BFS 2010 22

 • If φ(S ∗ ) = 0 for some S ∗ ∈ (S0 , H) then S ∗ is the early exercise
boundary b(vm , τn ) = bn
m at the grid point (vm , τn ).
− Once bn n n
m is found we integrate the equation for Vm backward from bm
toward S0 subject to the terminal condition

V (bn
m ) = 1.

• If φ(S) has no zero in [S0 , H) then there is no early exercise below

n
the barrier and we solve the equation for Vm subject to
n
n H − K − Wm (H)
Vm (H) = .
Rm (H)
− In fact, at any time to maturity τ , if the asset hits the barrier H, then the
option will be exercised, namely, C(H, v, τ ) = H − K, according to
the Riccati transform we have
n n n
Cm (H) = Rm (H)Vm (H) + Wm (H) = H − K.

Chiarella, Kang and Meyer BFS 2010 23

5 Numerical Examples

Parameter Value SV Parameter Value

r 0.03 θ 0.1
q 0.05 κv 2.00
T 0.5 σ 0.1
K 100 λv 0.00
ρ ±0.50 H 130

Table 1: Parameter values used for the barrier option. The stochastic volatil-
ity (SV) parameters are those used in Heston’s original paper.

Chiarella, Kang and Meyer BFS 2010 24

 ρ = −0.50, v = 0.1 S
Method (N, M, Spts ) 80 90 100 110 120
MOL (50,100,1140) 0.9045 1.8807 2.5978 2.4859 1.4858
MOL (100,200,6400) 0.9044 1.8781 2.5908 2.4769 1.4782
FD (200, 100, 200) 0.9029 1.8778 2.5903 2.4760 1.4775
MC (400, 20) 0.9355 1.9579 2.7407 2.6706 1.6773
MC upper bound 0.9389 1.9628 2.7464 2.6762 1.6820
MC lower bound 0.9321 1.9530 2.7351 2.6649 1.6726

Table 2: Prices of the continuously monitored barrier option without early

exercise features computed using method of lines (MOL), finite difference
(FD) and Monte Carlo simulation (MC). Parameter values are given in Table
1, with ρ = −0.50 and v = 0.1.

Chiarella, Kang and Meyer BFS 2010 25

 ρ = −0.50, v = 0.1 S
Method (N, M, Spts ) 80 90 100 110 120
MOL (50,150,1140) 1.4009 3.9350 8.2981 14.4015 21.8229
MOL (100,200,2440) 1.4012 3.9364 8.3003 14.4033 21.8219
MOL (100,200,6400) 1.4012 3.9363 8.3003 14.4032 21.8216
MOL (200,400,9100) 1.4015 3.9371 8.3014 14.4037 21.8201
MC (100, 20, 50) 1.3994 3.9238 8.2302 14.1086 20.9401
MC upper bound 1.4058 3.9347 8.2454 14.1261 20.9568
MC lower bound 1.3930 3.9129 8.2151 14.0909 20.9234

Table 3: Prices of the continuously monitored barrier option with early ex-
ercise features computed using method of lines (MOL) and Monte Carlo
simulation (MC). Parameter values are given in Table 1, with ρ = −0.50
and v = 0.1.
Chiarella, Kang and Meyer BFS 2010 26
 ρ = −0.50, v = 0.1 S
Method (N, M, Spts ) 80 90 100 110 120
MOL(50,100,1140) 1.0764 2.5173 4.0895 4.9894 4.8291
MOL (100,200,6400) 1.0807 2.5289 4.1116 5.0235 4.8706
COS (100, 200, 100) 1.0809 2.4871 4.0454 4.9779 4.8646
MC (400, 20) 1.0780 2.5257 4.1033 5.0166 4.8605
MC upper bound 1.0834 2.5339 4.1135 5.0279 4.8718
MC lower bound 1.0726 2.5175 4.0930 5.0054 4.8492

Table 4: Prices of the discretely monitored barrier option without early exer-
cise features computed using method of lines (MOL), Fourier Cosine expan-
sion (COS) and Monte Carlo simulation (MC). Parameter values are given in
Table 1, with ρ = −0.50 and v = 0.1.

Chiarella, Kang and Meyer BFS 2010 27

 ρ = −0.50, v = 0.1 S
Method (N, M, Spts ) 80 90 100 110 120
MOL(50,100,1140) 1.4008 3.9339 8.3010 14.4446 22.0389
MOL (100,250,2400) 1.4012 3.9364 8.3025 14.4182 21.8719
MOL (150,250,6400) 1.4014 3.9368 8.3028 14.4157 21.8615
MC (100, 20, 50) 1.4002 3.9338 8.2967 14.4285 21.9274
MC upper bound 1.4066 3.9449 8.3123 14.4473 21.9459
MC lower bound 1.3938 3.9228 8.2810 14.4097 21.9089

Table 5: Prices of the discretely monitored barrier option with early exercise
features computed using method of lines (MOL) and Monte Carlo simulation
(MC). Parameter values are given in Table 1, with ρ = −0.50 and v = 0.1.

Chiarella, Kang and Meyer BFS 2010 28

 Price profile continuous Barrier without early exercise

4.5

3.5

3
C(S,v,T)

2.5

1.5

0.5

0
1

0.8
220
200
0.6 180
160
0.4 140
120
0.2 100
80
0 60
v S

Figure 5: Price profile of a continuously monitored up-and-out call option

without early exercise opportunities.
Chiarella, Kang and Meyer BFS 2010 29
 Price profile discrete Barrier without early exercise

10

6
C(S,v,T)

0
1

0.8
220
200
0.6 180
160
0.4 140
120
0.2 100
80
0 60
v S

Figure 6: Price profile of a discretely monitored up-and-out call option with-

out early exercise opportunities.
Chiarella, Kang and Meyer BFS 2010 30
 Early exercise boundary of continuous barrier option

130

125

120
b(v,τ)

115

110

105

100
1

0.8
0.5
0.45
0.6 0.4
0.35
0.3
0.4 0.25
0.2
0.2 0.15
0.1
0.05
0 0
v
τ

Figure 7: Early exercise boundary of a continuously monitored up-and-out

call option.
Chiarella, Kang and Meyer BFS 2010 31
 Early exercise boundary of Discrete Barrier option

350

300

250
b(v,τ)

200

150

100
1

0.8
0.5
0.45
0.6 0.4
0.35
0.3
0.4 0.25
0.2
0.2 0.15
0.1
0.05
0 0
v τ

Figure 8: Early exercise boundary of a discretely monitored up-and-out call

option.
Chiarella, Kang and Meyer BFS 2010 32
 Delta profile continuous Barrier without early exercise

0.2

0.1

0
C (S,v)

−0.1

−0.2
S

−0.3

−0.4

−0.5
1
0.8 250
0.6 200
0.4 150
0.2 100
0 50
v S

Figure 9: Delta profile of a continuously monitored up-and-out call option

without early exercise opportunities.
Chiarella, Kang and Meyer BFS 2010 33
 Delta profile Continuous Barrier with early exercise

0.8

0.6
C (S,v)
S

0.4

0.2

0
1
0.8 250
0.6 200
0.4 150
0.2 100
0 50
v S

Figure 10: Delta profile of a continuously monitored up-and-out call option

with early exercise opportunities.
Chiarella, Kang and Meyer BFS 2010 34
 Delta profile Discrete Barrier without early exercise

0.3

0.2

0.1
C (S,v)

−0.1
S

−0.2

−0.3

−0.4
1
0.8 220
200
0.6 180
160
0.4 140
120
0.2 100
80
0 60
v S

Figure 11: Delta profile of a discretely monitored up-and-out call option

without early exercise opportunities.
Chiarella, Kang and Meyer BFS 2010 35
 Delta profile Discrete Barrier with early exercise

0.8
C (S,v)

0.6
S

0.4

0.2

0
1
0.8 250
0.6 200
0.4 150
0.2 100
0 50
v S

Figure 12: Delta profile of a discretely monitored up-and-out call option with
early exercise opportunities.
Chiarella, Kang and Meyer BFS 2010 36
6 Conclusions

• Set up a framework for pricing Barrier options under SV.

• Allow for early exercise features.

• Unify both continuously and discretely monitored options.

• Implement the method of lines approach.

• Some numerical examples.

• Future work:
− Incorporating jump diffusion as well,
− Pricing knock-in options under SV with early exercise features.

Chiarella, Kang and Meyer BFS 2010 37

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ican Barrier Options Using the Decomposition Technique’, Journal of
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Heston, S. (1993), ‘A Closed-Form Solution for Options with Stochastic
Volatility with Applications to Bond and Currency Options’, Review
of Financial Studies 6(2), 327–343.
Merton, R. C. (1973), ‘Theory of Rational Option Pricing’, Bell Journal of
Economics and Management Science 4, 141–183.
Rich, D. R. (1994), ‘The Mathematical Foundation of Barrier Option-Pricing
Theory’, Advances in Futures and Options Research 7, 267–311.

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Wong, H. Y. & Kwok, Y. K. (2003), ‘Multi-asset Barrier Options and Occu-
pation Time Derivatives’, Applied Mathematical Finance 10(3), 245–
266.

Zvan, R., Vetzal, K. & Forsyth, P. (2000), ‘PDE methods for pricing barrier
options’, J. Econ. Dyn. Control 24, 1563–1590.

Chiarella, Kang and Meyer BFS 2010 39