The British Russian Option

Kristoffer Glover, Goran Peskir and Farman Samee

No 269, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: Following the economic rationale of [10] and [11] we present a new class of lookback options (by first studying the canonical 'Russian' variant) where the holder enjoys the early exercise feature of American options where upon his payoff (deliverable immediately) is the 'best prediction' of the European payoff under the hypothesis that the true drift of the stock price equals a contract drift. Inherent in this is a protection feature which is key to the British Russian option. Should the option holder believe the true drift of the stock price to be unfavourable (based upon the observed price movements) he can substitute the true drift with the contract drift and minimise his losses. The practical implications of this protection feature are most remarkable as not only is the option holder afforded a unique protection against unfavourable stock price movements (covering thea bility to sell in a liquid market completely endogenously) but also when the stock price movements are favourable he will generally receive high returns. We derive a closed form expression for the arbitrage-free price in terms of the rational exercise boundary and show that the rational exercise boundary itself can be characterised as the unique solution to a nonlinear integral equation. Using these results we perform a financial analysis of the British Russian option that leads to the conclusions above and shows that with the contract drift properly selected the British Russian option becomes a very attractive alternative to the classic European/American Russian option.

Pages: 20 pages
Date: 2010-01-01
New Economics Papers: this item is included in nep-cis
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Published as: Glover, K., Peskir, G. and Samee, F., 2011, "The British Russian Option", Stochastics An International Journal of Probability and Stochastic Processes, 83(4-6), 315-332.

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