Robust Hedging of Barrier Options

Abstract

This article considers the pricing and hedging of barrier options in a market in which call options are liquidly traded and can be used as hedging instruments. This use of call options means that market preferences and beliefs about the future behavior of the underlying assets are in some sense incorporated into the hedge and do not need to be specified exogenously. Thus we are able to find prices for exotic derivatives which are independent of any model for the underlying asset. For example we do not need to assume that the underlying assets follow an exponential Brownian motion.We find model‐independent upper and lower bounds on the prices of knock‐in and knock‐out puts and calls. If the market prices the barrier options outside these limits then we give simple strategies for generating profits at zero risk. Examples illustrate that the bounds we give can be fairly tight.