Pricing Onion Options: A Probabilistic Approach

Thorsten Upmann

International Journal of Financial Research, 2013, vol. 4, issue 4, 11-25

Abstract: As argued by Ebenfeld, Mayr and Topper (2002), Onion options may be decomposed into one-touch double barrier binary options (ODBs). Using this idea, these authors provide an arbitrage-free pricing formula for Onion options within the Black-Scholes framework. Their approach rests upon solving the underlying partial differential equation. In this paper, we take an alternative and more direct route: Based on a probabilistic approach, we compute the risk-neutral valuation formula for an ODB. Then, by inverting the decomposition of an Onion option, we are able to derive an alternative pricing formula for this type of an option.

Keywords: onion options; one-touch double barrier binary options; double-notouch options; arbitrage-free pricing; Black-Scholes model (search for similar items in EconPapers)
Date: 2013
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