European contingent claim

A European contingent claim pays a specified function of market variables at one fixed maturity. Under an equivalent martingale measure, an attainable claim is priced by the discounted conditional expectation of its payoff.

A maturity-$T$ claim is attainable if a predictable self-financing strategy with fixed initial capital has terminal wealth equal to the claim payoff almost surely. In discrete time its wealth is $X_t=x+{\sum }_{s=1}^t{H}_s\cdot (P_s-P_{s-1})$. The strategy replicates the claim; attainability is a statement about exact pathwise replication, not only equality of expectations.

An option whose payoff depends on an average of the underlying stock prices over time. The displayed arithmetic-average call differs from a geometric-average call, which uses the geometric mean. A convex payoff and a nondecreasing positive numéraire give an upper bound by the average costs of same-strike European call options at the averaging dates.

An Asian option whose averaging uses the geometric mean. In the constant-coefficient Black-Scholes model, the logarithm of the continuous geometric average is Gaussian with mean $\log S_0+(r-{\sigma }^2/2)T/2$ and variance ${\sigma }^{2}T/3$, because $\mathrm{Var}({\int }_0^T{W}_{t}dt)=T^3/3$. Its forward mean is $S_0{e}^{rT/2-{\sigma }^{2}T/12}$. The discounted lognormal call formula gives its price. It is strictly cheaper than the terminal European call when $\sigma ,K,T>0$ and $r\ge -{\sigma }^2/6$, since both its forward mean and log-variance are no larger, with strictly smaller variance. No unconditional comparison holds for arbitrary negative interest rates: for $r<-{\sigma }^2/6$, sufficiently small positive strikes reverse the inequality.

For $I_t={\int }_0^t\log S_{u}du$ and $G_T=\exp (T^{-1}{I}_T)$ in the Black-Scholes model, the conditional law of $\log G_T$ under the risk-neutral measure has a normal distribution with mean $m_t$ and variance $q_t$. The future Brownian integral equals ${\int }_t^T(T-u)d{W}_u$, so the Itô isometry gives the variance. For strike $K>0$ and $t<T$, the call price is $e^{-\rho (T-t)}[e^{m_t+q_t/2}\Phi (d_1)-K\Phi (d_2)]$, where $d_2=(m_t-\log K)/\sqrt{q_t}$ and $d_1=d_2+\sqrt{q_t}$. This follows by completing the square in the truncated normal exponential moment; the known past integral must be included in the mean.

For sampling times $t_i$ and $\bar{t}=n^{-1}{\sum }_i{t}_i$, the geometric mean $A=({\prod }_i{S}_{t_i}{)}^{1/n}$ has $\log A$ normally distributed under the stock-numeraire measure in the Black-Scholes model. Its mean is $\log S_0+(\rho +{\sigma }^2/2)\bar{t}$, and its variance is $v={\sigma }^2{n}^{-2}{\sum }_{i,j}\min (t_i,t_j)$. For descending times the sum is ${\sum }_i(2i-1)t_i$. The drift shift comes from exponential tilting, and must be included when the delivered payment contains a factor $S_T$.

A delivery $S_T\max (r,c/A)$ has value $S_0[r\Phi (d)+c{e}^{-m+v/2}\Phi (-d+\sqrt{v})]$, where $m,v$ are the mean and variance of $\log A$ under the stock-numeraire measure in the Black-Scholes model, and $d=(m-\log (c/r))/\sqrt{v}$. Split the normal integral at $\log (c/r)$ and complete the square in $e^{-y}$ times its normal probability density.

The holder chooses at a specified time between a European call option and a European put option with the same later maturity and strike. Put-call parity makes its value equal to a call of the original maturity plus a put of the choice-time maturity with appropriately discounted strike.

A power option is a European contingent claim whose payoff is a fixed power of the terminal underlying price. In the Black-Scholes model, its value is $S_t^p\exp ((p-1)r(T-t)+\frac{1}{2}p(p-1){\sigma }^2(T-t))$ when the required moments are finite.

A binary option pays one fixed amount when a specified event occurs at maturity and zero otherwise.

A cash-at-maturity upper-barrier digital option pays a fixed amount if the stock touches an upper barrier by maturity. In the Black-Scholes model, write $a=\log (c/S_0)/\sigma$ and $b=-(r-{\sigma }^2/2)/\sigma$. Its unit-payoff price is $e^{-rT}$ times the linear-boundary Brownian first-passage distribution at $T$. This differs from paying at the hitting time, when the discount factor is random, and from an ordinary terminal-price digital option.

A contingent claim paying one at maturity if a specified price path has remained below an upper barrier, and zero otherwise. This survival payoff differs from a terminal digital put option, which tests only the terminal price. In the dividend-free Black-Scholes model, its value is the discount factor times the risk-neutral probability of avoiding the barrier, obtainable from the linear-boundary Brownian first-passage distribution.

A digital call option with strike $K$ pays one unit if $S_T\ge K$ and zero otherwise.

A barrier claim paying a fixed cash amount at the first time the stock reaches a higher level, provided this happens before expiry. In the Black-Scholes model, take $a=\log (c/S_0)/\sigma$ and $b=({\sigma }^2/2-\rho )/\sigma$. Its unit-cash price is ${\mathbb{E}}_Q[e^{-\rho T_{a,b}}{1}_{\{T_{a,b}\le T\}}]$, given by truncated discounted Brownian first passage. The effective square root $\sqrt{b^2+2\rho }=|\rho +{\sigma }^2/2|/\sigma$ is real for every real interest rate.

A digital put option with strike $K$ pays one unit if $S_T<K$ and zero otherwise. With these complementary boundary conventions, one digital call plus one digital put equals a zero-coupon bond paying one unit at maturity.