Rational Bounds on the Prices of Exotic Options

Neuberger, A J and Hodges, S (1998) Rational Bounds on the Prices of Exotic Options. Working Paper. London Business School IFA Working Paper.

Abstract

In this paper we provide a technique for pricing exotics relative to the instruments used for hedging them, while making minimal assumptions about price processes. The issue we address is this: given the prices of a set of hedging assets (such as a stock and a set of traded European options on that stock), what restrictions can be place on the price of an exotic option? The question has a natural formulation as a linear program. We show how to get price bounds. We also show the corresponding robust strategies which enforce those bounds. The strategies allow agents to write exotics and put a floor on their losses in all states of the world. For some common exotics such as a digital barrier option and a lookback, we provide simple characterizations for the bounds and the hedging strategies. For others, notably the forward straddle, we show numerical solutions.