Pricing and static hedging of European-style double barrier options under the jump to default extended CEV model

Abstract

This paper develops two novel methodologies for pricing and hedging European-style barrier option contracts under the jump to default extended constant elasticity of variance (JDCEV) model, namely: a stopping time approach based on the first passage time densities of the underlying asset price process through the barrier levels; and a static hedging portfolio approach in which the barrier option is replicated by a portfolio of plain-vanilla and binary options. In doing so, both valuation methodologies are extended to a more general set-up accommodating endogenous bankruptcy, time-dependent barriers and the commonly observed stylized facts of a positive link between default and equity volatility and of a negative link between volatility and stock price. The two proposed numerical methods are shown to be accurate, easy to implement and efficient under both the JDCEV model and the nested constant elasticity of variance model.