Static hedging of chained-type barrier options

Abstract

This paper concerns barrier options which are chained together. When the underlying asset price hits a certain barrier level, another barrier option is given to a primary option holder. Then, if the asset price hits another barrier, a third barrier option is given, and so on. The paper studies the hedging problem for these chained-type barrier options. We use the (double) reflection principle and propose a static replication portfolio of vanilla options for hedging of these options in the Black-Scholes model. The Monte Carlo simulation results for vanilla options with adjusted payoffs are provided to demonstrate the accuracy of the hedging strategies. A comparison between static hedging and delta hedging for a chained barrier option shows static hedge performs better than delta hedge. (C) 2015 Elsevier Inc. All rights reserved.