Barrier Options Primer

Option barrire : - Loption barrire activante appele knock-in option une valeur
lchance dpendant du fait que le sous-jacent atteigne ou non un certain niveau de cours dite
barrire, pendant la dure de vie de loption. Loption nest active que si elle atteint la
barrire, lchance sa valeur est la mme quune option standard, mais elle cote moins
chre quune option plain vanilla puisque plus risque. - Loption barrire dsactivante
appele knock-out option fonctionne de la mme manire que loption barrire activante
sauf que loption barrire est dsactive lorsque lactif sous-jacent atteint un certain niveau.

In finance, a barrier option is an exotic derivative typically an option on the underlying

asset whose price reaching the pre-set barrier level either springs the option into existence or
extinguishes an already existing option.

Where the option springs into existence on the price of the underlying asset breaching a
barrier, it may be known as an "up and in," "knock-in," or "down and in" option.

Where the option is extinguished on the price of the underlying asset breaching a barrier,
it may be known as an "up and out," "knock-out," or "down and out" option.

Barrier options are always cheaper than a similar option without barrier. Thus, barrier options
were created to provide the insurance value of an option without charging as much premium. For
example, if you believe that IBM will go up this year, but are willing to bet that it won't go above
$200, then you can buy the barrier and pay less premium than the vanilla option.

Barrier options are a modified form of standard options that include both puts and calls. They are
characterized by a strike level and a barrier level, as well as by a cash rebate associated with
crossing the barrier. As with standard options, the strike level determines the payoff at expiration.
The barrier options contract specifies, however, that the payoff depends on whether the stock
price ever crosses the barrier level during the life of the option.
In addition, Barrier options are sometimes accompanied by a rebate, which is a payoff to the
optionholder in case of a barrier event. Rebates can either be paid at the time of the event or at
expiration.

Types
Barrier options are path-dependent exotics that are similar in some ways to ordinary options. You
can call or put in American, Bermudan, or European exercise style. But they become activated (or
extinguished) only if the underlying reaches a predetermined level (the barrier).

Barriers come in two types: Up and Down Barriers

Up barrier: the barrier is above the current stock level; if it is ever crossed, it will be from below.
Down barrier: the barrier is below the current stock level; if it is ever crossed, it will be from
above.

Barrier options come in two types: In options and Out options

In options start their lives worthless and only become active in the event that a predetermined
knock-in barrier price is breached.
Out options start their lives active and become null and void in the event that a certain knock-out
barrier price is breached.
If the option expires inactive, then it may be worthless, or there may be a cash rebate paid out as
a fraction of the premium.

The four main types of barrier options thus

are:

Up-and-out: spot price starts below the barrier level and has to move up for the option to
be knocked out.

Down-and-out: spot price starts above the barrier level and has to move down for the
option to become null and void.

Up-and-in: spot price starts below the barrier level and has to move up for the option to
become activated.

Down-and-in: spot price starts above the barrier level and has to move down for the
option to become knocked-in.

For example, a European call option may be written on an underlying with spot price of $100 and
a knockout barrier of $120. This option behaves in every way like a vanilla European call, except
if the spot price ever moves above $120, the option "knocks out" and the contract is null and void.
Note that the option does not reactivate if the spot price falls below $120 again. Once it is out,
it's out for good. Also note that once it's in, it's in for good.
In-out parity is the barrier option's answer to put-call parity. If we combine one "in" option and one
"out" barrier option with the same strikes and expirations, we get the price of a vanilla
option:

. A simple arbitrage argumentsimultaneously holding the "in" and

the "out" option guarantees that exactly one of the two will pay off identically to a standard
European option while the other will be worthless. The argument only works for European options
without rebate.

Barrier options can have either American, Bermudan or European exercise style.

Barrier events
A barrier event occurs when the underlying crosses the barrier level. While it seems
straightforward to define a barrier event as "underlying trades at or above a given level," in reality
it's not so simple. What if the underlying only trades at the level for a single trade? How big would
that trade have to be? Would it have to be on an exchange or could it be between private parties?
When barrier options were first introduced to options markets, many banks had legal trouble
resulting from a mismatched understanding with their counterparties regarding exactly what
constituted a barrier event.

Barrier Monitoring
The Barrier can be monitored in two distinct manners. Unless specified, a Barrier is continuously
monitored; meaning that if the barrier is touched any time during the life of the option, the
Activation (In) or Deactivation (Out) is triggered.
A discrete barrier is one for which the barrier event is considered at discrete times, rather than the
normal continuous barrier case.
It is usual to specify the monitoring times at the writing of the Option.

Variations

A Parisian option is a barrier option where the barrier condition applies only once the
price of the underlying instrument has spent at least a given period of time on the wrong side
of the barrier.

A turbo warrant is a barrier option namely a knock out call that is initially in the money and
with the barrier at the same level as the strike.

Partial Barrier Options: For these options, the barrier is active only during an initial period.
In other words, the barrier disappears at a prescribed time. In general, the payoff at maturity
may be a function of the spot price at the time the barrier disappears.

Forward Starting Barrier Options: For these options, the barrier is active only over the
latter period of the options life. The barrier level may be fixed initially, or alternatively, may be
set at the forward start date to be a specified function of the contemporaneous spot price.
The payoff may again be a function of the spot price at the time the barrier becomes active.

Double Barrier Options: Options that knock in or out at the first hitting time of either a
lower or upper barrier.

Rolling Options: These options are issued with a sequence of barriers, either all below
(for roll-down calls) or all above (for roll-up puts) the initial spot price. Upon reaching each
barrier, the option strike is lowered (for calls) or raised (for puts). The option is knocked out at
the last barrier.

Ratchet Options: These options differ from rolling options in only two ways. First, the
strike ratchets to the barrier each time a barrier is crossed. Second, the option is not knocked
out at the last barrier. Instead, the strike is ratcheted for the last time.

Lookback Options: The payoff of these options depends upon the maximum or the
minimum of the realized price over the lookback period. The lookback period may start before
or after the valuation date but must end at or before the options maturity.