Analysis of American Discrete Barrier Option with Stochastic Rebate

Abstract

Unlike standard barrier options that pay a fixed amount of cash rebate when they are knocked out, a new type of American-style covered warrants appeared in Taiwan that has the unique feature of stochastic cash rebate. Available pricing models are not directly applicable to options with this innovative rebate specification and it is not clear if and how stochastic rebate affects its pricing and hedging operation. This article develops a valuation model that specifically considers the discrete nature of barrier monitoring and analyzes the impact of stochastic rebate on the pricing and hedging of barrier options. Our findings suggest that both the value and hedge parameters of this type of warrants can differ significantly from that of their fixed-rebate counterparts and it is therefore critical for both investors and issuers to account for this stochastic-rebate specification correctly when dealing with this type of option contracts.