J. Math. Sci. Univ.

Tokyo
5 (1998), 747785.

Pricing of Passport Option

By Izumi Nagayama
Abstract. Passport options are derivatives on actively managed
funds. There is no known explicit formula for the price of passport
options in general. We estimate and analyze the value function, and
give the condition that the optimal strategy becomes trivial. We also
show an approximation theorem which enables us to compute the value
function numerically. Finally we give the explicit formula for the value
function in the case that the interest rate is zero by using stochastic
analytic approach. This is somehow done in symmetric case by Hyer,
Lipton-Lifschitz, and Pugachevsky using partial dierential equation
approach.

1.

Introduction

Many traded securities are managed in the trading account. The value
of the trading account is the wealth accumulated by trading the securities
following to some trading strategies. The derivative security called Passport option is the contract that an option holder has the right to gain the
positive part of trading account at maturity. The option holder executes
a trading strategy (ctitiously) which is chosen by himself in the class of
strategies specied in the contract, and whenever the option holder changes
the position, he has to report the amount of security to the option writer.
In this paper we suppose that there is one traded security whose value
process St follows Black & Scholes model [1], i.e. under the risk neutral
measure P , St satises
(1.1)

dSt = St (rdt + dBt ),

where r and are constants and B is a P -Brownian motion. The value

Xt,x of trading account at time t under the strategy with initial value x
1991 Mathematics Subject Classication. Primary 90A09; Secondary 60J55.
Key words: passport option, Black & Scholes model, local time, Skorohods Theorem,
stochastic control.
747

748

Izumi Nagayama

is expressed as

Xt,x = x +

(1.2)

s dSs .

Let 1 < 2 . We denote by (1 , 2 ) the set of predictable processes

satisfying 1 t 2 for any t 0. The passport option whose pay-o is
a positive part of trading account at maturity T is evaluated by
C(T, x) =

(1.3)

sup
(1 ,2 )

E[erT (XT,x )+ ].

We dene Zt as a process which satises

dZt = Zt (rdt + dBt ), Z0 = 1
and dene
(t, y) =

def
(t, y) =
r,
1 ,2

sup

E[(y +
0

(1 ,2 )

u dZu )+ ].

x
).
S0
The optimal strategy which attain the supremum in (1.3) does not always exist in the strategy class (1 , 2 ), and the explicit formula of (1.3)
is not known in general.
In Section 2 we give the denition of passport option and show that its
price is given by (1.3).
In Section 3 we assume that r 0, 1 = 1, and 2 = 1. And letting

Then, we have C(T, x) = S0 erT (T,

0 (t, y) =

def
0r, (t, y) =

E[(y +
0

dZu )+ ] = E[(y + Zt 1)+ ],

we estimate (t, y) and
examine the conditions for = 0 . Let (x) =

x
x2
1
e 2 and (x) =
(y)dy. We have the following theorem as the
2

estimation of (t, y).

Theorem 1.1. For any c > 0, t > 0, and y R,
(t, y) 0 (t, y)
2

(e t 1) 2

c
2

+ 2

|y|

ec (1 e2 t )

1
4 3r2

e 22 t .

Pricing of Passport Option

749

For each T > 0, we dene

R (T ) = inf{r > 0 : r, (t, y) = 0r, (t, y)
def

for all r r , t [0, T ], and y R}.

We show the following results.
Theorem 1.2. Let c be the solution of
( 1 c). Then

1c
c( 1 c) =

3 c(1 32 c)

T
1c


2 (1 2c)
3 270c2 + 168c 32
c
131c
4 c
+
T + o(T ),
48(1 c)2
16(1 c)5/2
as T 0.

R (T ) = 2 c +

1
2 log(2 2 T )
,
Theorem 1.3. R (T ) =
+o
2
2( T + 1)
T2

as T .

Theorem 1.4. For any r, there exists T0 = T0 (r, 2 ) > 0 such that
0 (t, y) = (t, y),

for any t [0, T0 ] and y 1.

In Section 4, we prove that the value function of passport option can be

derived as the limit of discrete time approximation.
In Section 5, we consider the case that r = 0. Hyer, Lipton-Lifschitz
and Pugachevsky [2] derived the explicit formula in the case that 1 =
2 using partial dierential equation approach. We derive the explicit
formula in general case that 1 2 using stochastic analytic approach.
By introducing the Equivalent Martingale Measure P with respect to the
numeraire St , we show that the problem of passport option valuation comes
Y y )+ ] where
down to the problem of calculation of an expected value E[(
T
Yty is the solution of
t ,
dYt = (1 + |Yt |)dB

Y0 = y.

750

Izumi Nagayama

Using Skorohods Theorem, we derive the explicit formula for valuation of

passport options (see Theorem 5.6).
In Section 6, by numerical calculations we illustrate the functions r (t)
and (r (t), t) introduced in Section 3. Furthermore numerical experiences
in the discrete time framework discussed at Section 4 are reported.
The author expresses her sincere thanks to Professors Shigeo Kusuoka
and Freddy Delbaen for their kind advice and discussion.
2.

Notation and Problems

Let (Bt )0t< be a Brownian motion dened in a probability space

(, F, P ) and (Ft )0t< be the Brownian ltration generated by (Bt )0t< .
Let St be the price at time t of the security. We assume that St satises the
following S.D.E.
dSt = St (rdt + dBt ),
(2.1)
where r and are constants. To simplify the notation, we assume that the
probability measure P is risk neutral with respect to the numeraire ert .
A trading strategy is dened as a predictable stochastic process. For
xed 1 < 2 , we dene = (1 , 2 ) by the set of predictable processes
satisfying 1 t 2 for all 0 t < . For any and x R, let
(2.2)

Xt,x = x +

s dSs .

The processes {Xt,x }0t< are called trading accounts. For any ,
x R, and t 0, we have E[|Xt,x |2 ] < .
In this paper, a passport call option with maturity T is dened as a
contract that an option holder has the right to gain the positive part of the
trading account at time T under the trading strategy in chosen arbitrarily
by him. The option holder has to report the current value of the strategy
to the option writer at every moment.
Proposition 2.1. Let C(T, x, S, 1 , 2 ) be the value of the passport
call option of maturity T , where x is current value of the trading account
and S is the current price of the security. Then


C(T, x, S, 1 , 2 ) =

sup
(1 ,2 )

rT

E e


(XT,x )+ 
S0 =S

Pricing of Passport Option

751

To prove this proposition, we need some preparations. Let Zt be a

process given by the following S.D.E.
dZt = Zt (rdt + dBt ), Z0 = 1,


i.e. Zt = exp(Bt

1 2
2 t + rt).

Let

Ut,x

= sup E

for , x R, and t [0, T ]. Let

def

(t, y) =
(t, y) = r,
1 ,2

(Xt,x

sup

E[(y +

(1 ,2 )

+
t

u dSu )+ |Ft

u dZu )+ ].

Then it is easy to see that 0 (t, y2 ) (t, y1 ) y2 y1 for y1 y2 and

that Ut,x = St (T t,

Xt,x
St ).

Then we have the following.

Lemma 2.2. {Ut,x }0tT is a non-negative supermartingale.



Proof. E |UT,x | = E |XT,x | < . So the assertion follows from

E[Ut,x |Fs ]

sup E (x +

sup E (x +

u dSu +





u dSu )+  Fs


u dSu +


u dSu )+  Fs





= Us,x ,

s < t.

Here the rst inequality is derived as follows. For any y
R and n N there
T t
1
uy,n dZu )+ ] < .
exists a y,n such that 0 (T t, y) E[(y +
n
0
Then there is a predictable measurable function F y,n : [0, ) C([0, ))
1 + 2
R such that y,n = F y,n (, B ). Dene n such as sn =
, s t and
2
k
X ,x ()
k+1
n
n
t+u
() = F k2 ,n (u, B+t () Bt ()), if n t
. Then
<
2
St ()
2n
n , and


Xt,x
X ,x
1
+
n < (T t, t ) E
2
St
St

t

+ 

1
1
sn dZs  Ft < + n
n 2


a.s.

752

Izumi Nagayama

T
Xt,x
X ,x
sn dZs
Therefore (T t, t ) = lim E
+
n
St
St
t
by the dominated convergence theorem we have

E[Ut,x |Fs ]

lim E

(Xt,x

sup E (Xt,x +

+ 

 Ft , a.s. Then






un dSu )+  Fs


 


u dSu )+  Fs . 


Proposition
2.1.
 Proof of

T
rT
+

Suppose that C(T, x, S, 1 , 2 ) <

E e
(x + 0 s dSs )
for some . The representation theorem
of Brownian martingale implies that the European call option of the maT
+ is replicable with initial cost
turity
T
with
pay-o
(x
+
0 s dSs )



E erT (x + 0T s dSs )+ . If we think of the strategy to buy a passport
option by value C(T, x, S, 1 , 2 ) and to take trading strategy while replicate
position of that European call option with initial gain
 the short

E erT (x + 0T s dSs )+ , we see that it is an arbitrage strategy. There

fore C(T, x, S, 1 , 2 ) sup E erT (x +

s dSs )+ .

rT

Suppose that C(T, x, S, 1 , 2 ) > sup E e


(XT,x )+ 
S0 =S

. Then we

sell the passport option by value C(T, x, S, 1 , 2 ). Suppose the option

holder takes a trading strategy . From Lemma 2.2, {erT Ut,x }0tT is a
non-negative supermartingale, so it has a unique decomposition erT Ut,x =
,x
,x
Mt,x A,x
t , where {Mt } is a square integrable martingale and {At } is
a non-decreasing predictable process with A0 = 0. Let St = ert St , then
we have dSt = St dBt and S is a P -martingale. From the representation
theorem of Brownian martingales, there exists an adapted process {Ht } such

that E[ 0T Hs2 Ss2 ds] < and
Mt,x

M0,x

+
0

Hs dSs .

Ht can be determined at time t from Ft and {s : s t} which has been

reported by the option holder. Then by taking the position of Ht units of St
and ert Mt,x Ht St amount of saving account, we can replicate erT MT,x =

Pricing of Passport Option

753

,x +
rT ,x
rT ,x
UT,x + erT A,x
T = (XT ) + e AT . Then we will have the gain e AT 0
at time T . Since the initial gain was C(T, x, S, 1 , 2 ) M0,x > 0, it is an
arbitrage. 

For any positive constant , by considering the passport option

whose underlying is times the original underlying, we have that
C(T, x, S, 1 , 2 ) = C(T, x, S, 1 , 2 ). And by changing time, we have
2
C r, (T, x, S, 1 , 2 ) = C r/ ,1 ( 2 T, x, S, 1 , 2 ).
Proposition 2.3. (t, y) is convex, increasing, and Lipschitz with respect to y. Moreover if 1 0 2 , (t, y) is increasing in t.
Proof. For any convex function g and 0 1, we have
sup E[g(x + (1 )y +

sup E[g(x +

sup E[g(x +

0
t

u dZu )]

u dZu )] + (1 )E[g(y +

u dZu )] + (1 ) sup E[g(y +

u dZu )]

u dZu )].

Therefore (t, ) is convex. We can easily see that (t, y) is increasing and
Lipschitz with respect to y. Let 1 0 2 and s < t, then

(t, y) = sup E[(y +

0

3.

u dZu )+ ] sup E[(y +

u dZu )+ ] = (s, y). 

The Estimation of the Value Function

In this section, we assume r 0, 1 = 1, and 2 = 1. By Proposition

2.1, C(t, x, S) = Sert (t, Sx ). Let
0 (t, y) =

def
0r, (t, y) =

E[(y+
0

dZu )+ ] = E[(y+Zt 1)+ ] ,

Then obviously we have (t, y) 0 (t, y). Let

x2
1
(x) = e 2
2

and

(x) =

(y)dy.

t 0, y R.

754

Izumi Nagayama

Theorem 3.1. For any c > 0,

(t, y) 0 (t, y)
1

(e t 1) 2

c
2

+ 2

|y|

ec (1 e2 t )

Proof. For each , let = inf{t > 0 : y +

let us assume that y 0. Then we have


(t, y) = sup E[y +

s dZs ] + E[(y +

0 (t, y) + sup E[(y +

0

t
0

1
4 3r2

e 22 t .

s dZs = 0}. First,



s dZs ) , t > ]

s dZs ) , t > ].

Recall that dZt = Zt (rdt+dBt ). Dene a P -equivalent probability measure

def
def r
r
r2
Q by ( dQ
dP )t = t = exp( Bt 2 2 t). Since Wt = t + Bt is a Q-Brownian
motion, Z is a Q-square integrable martingale. Then, for each , we
have


E (y +
0

s dZs ) , t >



t





E  s dZs  I{t> }
0


t



1
Q 

= E  s dZs  I{t> }
t
0
1
 



 1
 t
2 2 Q
1
1 4
Q 
Q

E  s dZs 
E [I{t> } ] 4 E
.
4
0

Here we have E Q

Mt =

1
1
3r
3r2
=
E
=
E
exp
+
t
B
t

2 2
4t
3t



6r 2

= e 2 t . Let

s dZs , then we have

[M, M ]t =

0

s2 d[Z, Z]s

0

2 Zs2 ds = 2

Therefore we have

exp(2Ws 2 s)ds.



2 

t
t


2
2
Q 
2

e s ds = (e t 1).
E  s dZs 
0

Pricing of Passport Option

755

By Knights theorem (see Ikeda and Watanabe [3]) there exists a Q t }t[0,) such that Ms = W
[M,M ] . Therefore we have
Brownian motion {W
s
for any c > 0


inf Ms < y = Q

E Q [I{t> } ] = Q

0st

inf

0s[M,M ]t

s < y
W

s : 0 s (1 e2 t ) exp(2 max Wu )} < y

Q inf{W


0ut

Q max Wu c + Q
0ut

inf

0s(1e t )e2c

s < y .
W

a
It is well known that Q[ max Wu a] = 2 for a > 0. So we have
0ut
t



c
y
. Therefore we have
E Q [I{t> } ] 2 + 2
t
ec (1 e2 t )
our assertion in the case that y 0.
We can prove the case of y < 0 similarly. 

By Theorem 3.1, we can easily prove that for any p > 0, there exists
cp > 0 such that (t, y) 0 (t, y) + cp |y|p/2 , |y| 1. Therefore we have
1
(t, y) = 1, and
y
+

(t,
y)
=
lim
(t, y) = 1.
lim
y y +
y y
lim (t, y) = 0,

lim

In the rest of this section, we examine the condition such that = 0

is satised.
Remark 3.2.

We can easily see the following.

0 (t, y) =

(y + e

(r,y,t,)
y + ert 1

where (r, y, t, ) =

tx 12 2 t+rt

x2

e 2
1) dx
2

if y < 1
if y 1

log(1 y) 12 2 t + rt

for t > 0, y < 1.

t

756

Izumi Nagayama

For each T > 0 and > 0, dene

R (T ) = inf{r > 0 : r, (t, y) = 0r, (t, y)
for all r r , t [0, T ], and y R}.


Vt,x

Let

Then {Vt1,x }0tT

X ,x
T t, t
, for , x R, 0 t T .
St
is a martingale. Let

def
Vt,x,r, =

St 0r,

F (r, y, t, ) = r

2 0
0
(t, y).
(t, y) y 2
y
y 2

Lemma 3.3. For any T > 0 and > 0,

R (T ) = inf {r : F (r, y, t, ) 0, for any y (0, 1), t (0, T ]} .


Proof. Noting that

VT,x

x+
0

+

t dSt

, we have the following

from the proof of Proposition 2.1.

R (T ) = inf{r > 0 : {Vt,x,r, }0tT is a P -supermartingale,
for all r r , x R, and }.
So it is sucient to show that {Vt,x,r, }0tT is a P -supermartingale for
all and x R if and only if F (r, y, t, ) 0 for all y (0, 1) and
t (0, T ]. Let
,x
def X
Yt,y = t ,
(3.1)
x = yS0 .
St
Then by Itos formula we have
dYt,y = (t Yt,y )(rdt + dBt 2 dt)
and
dVt,x,r, = V (St , Yt,y , t , T t)dBt + V (St , Yt,y , t , T t)dt,

Pricing of Passport Option

757

where
0
(t, y) + S0 (t, y)
y
0
0
V (S, y, , t) = rS( y)
(t, y) S
(t, y)
y
t
2 0
1
(t, y) + rS0 (t, y).
+ S( y)2 2
2
y 2

V (S, y, , t) = S( y)

Since {Vt1,x,r, }0tT is a martingale, we have V (S, y, 1, t) = 0 for all

t (0, T ]. Note that {Vt,x,r, }0tT is supermartingale if and only if
V (S, y, , t) 0 = V (S, y, 1, t) for any y R, S > 0, t (0, T ], || 1.
This is equivalent to
r

(3.2)

0
2
2 0
(t, y) 0,
(t, y) + ( + 1 2y)
y
2
y 2
for y R, t (0, T ], || 1.

Since 0 (t, y) is convex in y, we have

2 0
0, and so the condition (3.2)
y 2

is equivalent to that
(3.3)

F (r, y, t, ) = r

0
2 0
(t, y) 0,
(t, y) y 2
y
y 2

t (0, T ]

for all y R. Here we have

1
if y 1
((r, y, t, )) if y < 1

0
if y 1
2 0
(t,
y)
=
1
((r, y, t, )) if y < 1.
y 2
(1y) t
0
(t, y) =
y

So in the case that y 1 or y 0, condition (3.3) is satised for all

t (0, T ]. This proves our assertion. 
Remark 3.4.
(3.4)
(3.5)

From Remark 3.2, we have the following.

F (r, y, t, ) = r((r, y, t, ))
F
(r, y, t, ) = ((r, y, t, ))
r

y
((r, y, t, ))
(1 y) t

758

Izumi Nagayama

+((r, y, t, ))

t
y
r+
(r, y, t, )

1y

F
1
((r, y, t, ))

(3.6)
(r 2 )t 2 ty y log(1 y)
(r, y, t, ) =
2
3
y
2
(1 y) t
F
(3.7)
(r, y, t, ) = ((r, y, t, ))
t


2(1 y) t3

y(r, y, t, )

+ r+
(1 y) t

log(1 y) 12 2 t + rt

2 t3

Lemma 3.5. R (T ) 2 .
F
(r, y, t, ) 0 for all r 2 , y (0, 1)
r
and t (0, T ]. So it is sucient to show that F ( 2 , y, t, ) 0 for all
y (0, 1) and t (0, T ]. From (3.6), we have
Proof. From (3.5), we have

F 2
( , y, t, )
y

if 0 < y 1 e 2 t
1 2
if 1 e 2 t y < 1.
1

0
0

It is sucient to show that F0 (t) = F ( 2 , 1 e 2 t , t, ) 0 for all t > 0.

1 2

(e 2 t 1)


( t) 0, F0 (t) is an increasing function.

Since F0 (t) =
2 t3
Also,
1

def

(e 2 t 1)
2

( t) =
lim F0 (t) = lim ( t) lim
.
t0
t0
t0
2
t
2

Therefore F ( 2 , 1 e 2 t , t, )
1

2
2

for all t > 0. 

Lemma 3.6. Let r < 2 . Then for each t > 0, there exists a unique
(r, t) (0, 1) such that F (r, (r, t), t, ) = min F (r, y, t, ).
y(0,1)

F
((r, y, t, ))
> 0. So from (3.6),
(r, y, t, ) > 0
y
(1 y)2 t3
1
(< 0) if and only if f (y) = (r 2 )t 2 ty y log(1 y) > 0 (< 0,
2
Proof. Note that

Pricing of Passport Option

759

1
y
respectively). Note that f  (y) = 2 t log(1 y) +
. So f  (y) is
2
1y
1
increasing in y (0, 1). Also we have f  (0) = 2 t < 0, lim f  (y) = ,
y1
2
f (0) = rt 2 t < 0, and lim f (y) = . So we see that the equation
y1

F
(r, y, t, ) = 0 in y has a unique solution and it gives the minimum of
y
F (r, , t, ). 
Remark 3.7. The proof of Lemma 3.6 shows that (r, t) is a solution
F
of
(r, y, t, ) = 0. Therefore (r, t) is characterized as a solution of
y
(3.8)

log(1 (r, t)) =

Then we have
(3.9)

rt 2 t 1 2
t,
(r, t)
2

0 < (r, t) < 1.

r t
2 r
t+
.
(r, (r, t), t, ) =
(r, t)

By (3.8) we see that lim{(r, t) log(1 (r, t))} and lim{(r, t)

t0

log(1 (r, t))} = . This implies

(3.10)

lim (r, t) = 0 and lim (r, t) = 1.

t0

Lemma 3.8. For r (0, 2 ), (r, t) =

r
t( 2 r) + t + o(t) as t 0.
4

Proof. Note that we have log(1 x) = x(1 + R(x)), where R(x) =

1 i
x , for |x| < 1. From Equation (3.8), we have
i+1
i=1

"

1
(r, t)2 (1 + R((r, t))) 2 t(r, t) ( 2 r)t = 0.
2
Since (r, t) (0, 1), we have

#
2 t + 4 t + 16( 2 r)(1 + R((r, t)))
(3.11)
.
(r, t) = t
4(1 + R((r, t)))

760

Izumi Nagayama

(r, t) #
So lim = 2 r. Let f (t) = (r, t) 2 r t . Then from (3.8)
t0
t
we have

( t( 2 r) + f (t)) log(1 t( 2 r) f (t))

1
+ 2 t( t( 2 r) + f (t)) + ( 2 r)t = 0.
2
Since we have
log(1

t( 2 r) f (t)) = log(1


where R(t)
= R

t( 2 r))

f (t)

(1 + R(t))
1 t( 2 r)
#

f (t)
#
, f (t) is the solution of the following
1 t( 2 r)

equation.
At f (t)2 + Bt f (t) + Ct = 0,
where At =

1 + R(t)
#
1 t( 2 r)

Bt = log(1
#

Ct =

t( 2 r))

t( 2 r)(1 + R(t))
1
#
+ 2t
2
2
1 t( r)

t( 2 r) log(1 t( 2 r))

1
+ 2 t t( 2 r) + ( 2 r)t.
2

#
Bt
Ct
1
Since lim At = 1, lim = 2 2 r, and lim = ( 2 r)3/2 +
t0
t0
t0
2
t
t3
f (t)
1 2# 2
r
r, we have lim
= .
t0
2
t
4

We can show the following lemma similarly to Lemma 3.8.

Lemma 3.9. For r (0, 2 ),

(r, t) =

r
3r2 12r( 2 r) 16( 2 r)2 3/2

t( 2 r) + t +
t
4
96 2 r

+o(t t) as t 0.

Pricing of Passport Option

761

Let G(r, t) = F (r, (r, t), t, ). Then we have the following.

Proposition 3.10. For each t > 0, the equation G(r, t) = 0 in r has a
unique solution r (t) in (0, 2 ). Moreover r (t) is continuous in t (0, ).
Proof. Note that by (3.5) we have
G
(r, t) = ((r, (r, t), t, ))
r

r 2
t
(r, t) (r,t) t + rt

+((r, (r, t), t, ))

r+

1 (r, t)
t
> 0

for 0 r < 2 .


(r 2 )t 1 2
From (3.8) we have (r, t) = 1exp
t . Since 0 < (r, t) <
(r, t)
2
1 we have 0 < lim inf (r, t) lim sup (r, t) < 1. Therefore lim G(r, t) < 0.
r0

r0

r0

We also have lim inf (r, t) > 0 from (3.8), so lim (r, t) = 1 e 2 t . This
1

r 2

r 2

2
(see the proof of
2
r 2
Lemma 3.5). So we have the rst assertion and we complete the proof by
implicit function theorem. 

implies that lim G(r, t) = F ( 2 , 1 e 2 t , t, )

1

Corollary 3.11. R (T ) = max r (t). In particular, R (T ) < 2 .

0tT

Proposition 3.12. lim r (t) = c 2 , where c is the solution of

t0

c( 1 c) = 1 c( 1 c).
Proof. Let G0 (r) = lim G(r, t). Then we have
t0

G0 (r) = r
and

 #
1

2 r 2 r

 #
1

2 r ,

G0 (c 2 ) = c 2 ( 1 c) 2 1 c( 1 c) = 0.

762

Izumi Nagayama

G0 (r)

 #
1

r > 0, we have G0 (c 2 8) < 0 < G0 (c 2 + 8),

for any 8 > 0. So by Proposition 3.10 lim r (t) = c 2 . 

Since

t0

We get c = 0.2945... by numerical calculation.

Proposition 3.13. R (T ) = 2 c+

3 c(1 32 c)

T +o( T ), as T 0.
1c

Proof. Let H(t, a) = G(c 2 + a t, t), where c is the value dened in

Proposition 3.12. By Lemma 3.8 we have

(c 2 + a t, t) = 1 c t

a
c 2

4
2 1 c

t + o(t).

Therefore we have from (3.9)

(c 2 + a t, (c 2 + a t, t), t, )

2 (1 c) a t
$
%
+
c
t
+
o(
t)
=

3
2 1 c 2a1c c4
t

1 c + h(a) t + o( t),
=
where h(a) =

2 2

a
3

+ c. And we have
1c 4

(c 2 + a t, t)

(1 (c 2 + a t, t)) t

$
%

3
2 1 c 2a1c c4
t

$
% + o( t)
=

2
1 1 c t + 2a1c c4 t

= 2 1 c + k(a) t + o( t),

3c 3
a
+ 3
. Since (x + z) = (x) + (x)z +
where k(a) =
4
2 1c
o(z) as z 0 and (x + z) = (x) x(x)z + o(z) as z 0 , we have

H(t, a) = (c 2 + a t){( 1 c) + ( 1 c)h(a) t + o( t)}

( 2 1 c + k(a) t)

{( 1 c) 1 c( 1 c)h(a) t + o( t)}.

Pricing of Passport Option

763

Therefore from the denitions of c, we have

H(t, a)
a 1c
2
H0 (a) = lim
= ( 1 c){c h(a)+
+ 2 (1c)h(a)k(a)}.
t0
c
t
Noting that

H0 (a)

1 2c
> 0 and H0
= ( 1 c)
c 1c

3 c(1 32 c)

1c
3
3
c(1 2 c)

3 c(1 32 c)

1c

= 0,

3 c(1 3 c)

8) < 0 < H0 ( 1c2 + 8) for any 8 > 0. So r (t) =

t + o( t). By Corollary 3.11, we have our assertion. 

we see H0 (
c 2 +

1c

We can also show the following. Although we need ner computation,

the idea of the proof is similar and so we omit the proof.
Theorem 3.14.
3 c(1 32 c)

T
1c


c2 (1 2c)
131c3 270c2 + 168c 32
4
c
+
T
48(1 c)2
16(1 c)5/2

R (T ) = 2 c +

as T 0.

+o(T ),

We also have the following theorem.



1
2 log(2 2 T )
, as T .
+o
Theorem 3.15. R (T ) =
2
2( T + 1)
T2

Proof. For each h R, set r0 (h, t) = 2

2 log(2 2 t) h
+ 2 . Then,
2( 2 t + 1)
t

(3.8) yields
2

2 t

0 (h, t) = (r0 (h, t), t)) = 1 e

= 1 o(e

2 t log(2 2 t)
h
exp
+
2
2( t + 1)0 (h, t) t0 (h, t)

2
t
2

as t ,

764

Izumi Nagayama

and we have from (3.9)

0 (h, t)

def

(r0 (h, t), 0 (h, t), t, )





2 t log(2 2 t)
1
h

1
= t+
2( 2 t + 1)
0 (h, t)
t t
as t .

Then we have

(0 (h, t))
t(1 0 (h, t))


log(2 2 t) h

= exp
2( 2 t + 1)
t


2 

1 2 t log(2 2 t)
1 0 (h, t) 2
h
exp
.

2

2( 2 t + 1)
0 (h, t)
t t
Therefore we have
G(r0 (h, t), t) = r0 (h, t)(0 (h, t)) 0 (h, t)


2 log(2 2 t)
h

+ 2
2
2( t + 1)
t
2



(0 (h, t))
t(1 0 (h, t))


(x)dx
0 (h,t)

log(2 2 t) h
0 (h, t) exp

2( 2 t + 1)
t


2 

1 2 t log(2 2 t)
1 0 (h, t) 2
h
exp

2

2( 2 t + 1)
0 (h, t)
t t
2

 

1
h
2h
+
+o
2
t
t
t

as t .

So we have tG(r0 (h, t), t) 2 h as t . Consequently, we have r (t) =

 
1
2 log(2 2 t)
2
as t , since G is increasing in r by Propo+
o
2
2( t + 1)
t2
sition 3.10. So Corollary 3.11 implies our assertion. 
Theorem 3.16. For any r > 0, there exists T0 = T0 (r, 2 ) > 0 such
that
0 (t, y) = (t, y), 0 t T0 , y 1.

Pricing of Passport Option

765

In order to prove this theorem, we show some propositions. Let Yt,y be

the process given by (3.1). Note that we have the following by Itos formula.
d(ert St1 ) = ert St1 (dBt 2 dt).
def

Let t = exp Bt 12 2 t and dene the probability measure



dP
t def
= t . Then B
= t + Bt is a P - Brownian motion.
dP t
ert St1 is a martingale under the measure P , P is EMM with respect
numeraire St . By applying Itos formula to (3.1), we have
(3.12)

t + rdt),
dYt,y = (t Yt,y )(dB

P by
Since
to the

Y0,y = y.

1 X] for any FT
Moreover by denition of P , we have E[erT X] = S0 E[S
T
] denotes the expectation under
measurable random variable X, where E[
P . So we have


(Y ,x/S )+ .
(3.13)
C(T, x, S) = S sup E
T


y) = sup E
(Y 1,y )+ . Then (t, y) =
(Y ,y )+ and 0 (t, y) = E
Let (t,
T
T

y) and 0 (t, y) = ert 0 (t, y), so (t, y) = 0 (t, y) if and only if

ert (t,
y) = 0 (t, y).
(t,
Proposition 3.17. Yt1,y 1, P -a.s, for all y 1.

Proof. From (3.12) we have that Yt1,y = 1 + (y 1)eBt rt 2

if y 1. 


2t

1,y Y ,y ] = r t er(st) E[(1

s )]ds, for
Proposition 3.18. (1) E[Y
t
t
0
all and t > 0.
2 
1,y

s )2 ]ds, for all and t > 0.

(2) E[(Y
Yt,y )2 ] 2 2 e2 t 0t E[(1
t
Proof. (1) Let Ut = Yt1,y Yt,y . Then
t + rdt)
dUt = {(1 t ) Ut }(dB
U0 = 0.

766

Izumi Nagayama

Therefore

d
t ] rE[U
t ] . So E[U
t] = r
E[Ut ] = rE[1
dt

s )]ds.
(2) Similarly we have by Itos formula,

er(st) E[(1

d 2

t ) Ut }Ut ] + 2 E[{(1
t ) Ut }2 ]
E[Ut ] = 2rE[{(1
dt
2 ] + 2 E[(1
t (1 t )]
t )2 ] + 2(r 2 )E[U
= ( 2 2r)E[U
t
2
2
2
2
2
t ] + ( + | r|)E[(1
t )2 ].
{( 2r) + | r|}E[U
Therefore we have from Gronwalls inequality
t2 ] ( 2 + | 2 r|) exp({( 2 2r) + | 2 r|}t)
E[U
2 2 e2

2t

s )2 ]ds
E[(1

s )2 ]ds. 
E[(1

Proposition 3.19. There exists a constant K = K(r, 2 ) such that

P ( sup |Ys1,y Ys,y | > 1) KtE[

0st

(1 s )2 ds],

for any and t [0, 1].

Proof. Letting Ut = Yt1,y Yt,y , we have

Ut =

s
(1 s )dB

s + r
Us dB

(1 s )ds r

0

Us ds.

So we have


P ( sup |Us | > 1) P sup |

0st

0st

+P sup |
0st



+P r

u | > 1
(1 u )dB
4

0

u | > 1
Uu dB
4

1
|1 s |ds >
4



+ P r

1
|Us |ds >
.
4

Pricing of Passport Option

Note that


P r

1
|1 s |ds >
4

767



16r2 E

|1 s |ds



16r tE

2 

(1 s ) ds .
2

Also by Proposition 3.18 (2)



P r

|Us |ds >

1
4



16r2 tE

2 2 2 2 t

32r e

Us2 ds


tE
0

(1 s ) ds .
2

By Doobs inequality


P sup |

0st

u | > 1
Uu dB
4

16 E

sup |



0
t



= 64 E
2

0
2 2 t

128 e

0st

|
64 2 E

u |
Uu dB

s |2
Us dB


Us2 ds


tE

(1 s ) ds .
2

By Burkholders inequality there exists some constant C4 such that



P sup |
0st

0

u | > 1
(1 u )dB
4



(
C4 4 E

4 E
4 4



(1 s )2 ds)2 4C4 4 tE

Proof of Theorem 3.16.

sup |

0st

0

u |
(1 u )dB

(1 s )2 ds . 

If x 1 and y R, then

x+ y + = x y 1{y0} |y| x y 1{|xy|1} |x y|.

Therefore for each , if ert r (8 2 Ke2 t )1/2 t1/2 0
2

1,y +
,y +

E[(Y
t ) ] E[(Yt ) ]

768

Izumi Nagayama

1,y Y ,y ] E[|Y
1,y Y ,y |, |Y 1,y Y ,y | 1]
E[Y
t
t
t
t
t
t
1,y Y ,y ] E[|Y
1,y Y ,y |2 ]1/2 P (|Y 1,y Y ,y | 1)1/2
E[Y
t

rE[

er(st) (1 s )ds]

22 t
2 E[e

!1/2

KtE[

(1 s ) ds]
2

(ert r (8 2 Ke2 t )1/2 t1/2 )E[

0
t

!1/2

(1 s ) ds]
2

(1 s )ds] 0. 

We can obtain similar results in the case of r < 0 similarly.

4.

Discrete Time Approximation

Let us x T > 0 and assume r 0. We introduce the discrete time

framework. Let N be any positive integer, and let
T
,
N
N = { : t = n , for t [n, (n + 1)), n = 0, 1, , N 1},

= N =

N
YtN, ,y = y +

N
1
"

N,N ,y
N
(n
Yn
)

n=0

t(n+1) B
tn ) + r(t (n + 1) t n)},
{(B
and

Y N,N ,y )+ ].
N (m, y) = sup E[(
m
N N

We will consider the optimal trading strategy in the case of discrete time
framework.
Proposition 4.1. N (m, ) is convex and
&

N m 1, y + (2 y)( B
+ r)
N (m, y) = max E


%

N m 1, y + (1 y)( B
+ r)
E

%'

Pricing of Passport Option

769

Proof. This can be shown inductively. Let us assume that N (m

1, y) is convex in y. Then we have
N (m, y) =

sup

1 k2

E[

+
=

sup

1 k2

sup

N ,0 =k
m1
"

+ (k y)( B
+ r)
E[(y

N,,y
(n+1) B
n ) + r))+ |F ]]
(n Yn
)((B

n=1
N

+ r))]
E[ (m 1, y + (k y)( B

&

+ r))],
N (m 1, y + (1 y)( B
max E[

'

N (m 1, y + (2 y)( B
+ r))] .
E[
The opposite side of the inequality is trivial. And so N (m, y) is convex in
y. 
Lemma 4.2.

,y 2
2
2
2 2
2 2 t

sup E[(Y
.
t ) ] (y + 2 max{1 , 2 }t)e

t +rdt)+ 2 (t Y ,y )2 dt
Proof. Since d(Yt,y )2 = 2Yt,y (t Yt,y )(dB
t
for any , we have the following similarly to Proposition 3.18 (2).
d ,y 2
,y 2
2
2

2
E[|Yt | ] {( 2 2r) + | 2 r|}E[(Y
t ) ] + ( + | r|)E[t ].
dt
Therefore we have
,y |2 ] (y 2 + 2 2
E[|Y
t

0

2 ]ds) exp(2 2 t)
E[
s
2

(y 2 + 2 2 max(21 , 22 )t)e2 t . 

Lemma 4.3. Let b 0, c 0 and let {an }n0 be a sequence of numbers

such that a0 = 0 and
an b + c

n1
"
k=0

Then an b(1 + c)n1 .

ak ,

n 1.

770

Izumi Nagayama

Proof. We show our assertion by induction. It is easy to verify it in

case of n = 1. Let an b + c

n1
"

ak b(1 + c)n1 . Then we have

k=0

an+1 b + c

n
"

ak b(1 + c)n1 + can b(1 + c)n . 

k=0

Lemma 4.4. There exists a sequence {CN } such that CN 0 as N

such that


|Y ,y Y N,,y |2 1 + 4( 2 + r2 T ) T
E
T
T
N

N 1

CN ,

for any N .
Proof. Let N . From the denitions of YTN,,y and YT,y we have

|YN,y

2
YNN,,y
|

2( + r T )E
2

= 4( 2 + r2 T )

N 1

"

(n+1)

n=0 n
N
1
"
(n+1)
n=0

+4( + r T )

N
1
"

|Yt,y

N,,y 2
Yn
| dt

|Y ,y Y ,y |2 dt
E
t
n


|Y ,y Y N,,y |2 .
E
n
n

n=0

,y
,y
N
Since we have Yt,y = Yn
+ (n
Yn
)(1 e(Bt Bn )(
n t < (n + 1), we have

(n+1)

2
+r)(tn)
2

) for

|Y ,y Y ,y |2 dt
E
t
n

(n+1)

=
n

,y 2
N
(n
Yn
) (1 e(Bt Bn )( 2
E


+r)(tn) 2

dt

2
1
2
(e(2r+ ) 1) ,
K (1 er ) +
2
r
2r +
where K = 2(y 2 + 2 2 max{21 , 22 }T )e2
Therefore


|Y ,y Y N,,y |2
E
N
N

2T

,y
N 2

+ 2 supN E[(Y
n n ) ].

Pricing of Passport Option

771

2(1 er ) e(2r+ ) 1
4( + r T )KN
+
r
2r + 2
2

+4( + r T )

N
1
"

|Y ,y Y N,,y |2 .
E
n
n

n=0

So by Lemma 4.3


|Y ,y Y N,,y |2
E
N
N




2(1 er ) e(2r+ ) 1
4( + r T )KN
+
r
2r + 2
2

1 + 4( 2 + r2 T )

%N 1

$ %
2(1 er ) e(2r+ ) 1
=
O
2 , we have our assertion. 
+
r
2r + 2
2

Since

Proposition 4.5.

y).
lim N (t, y) = (t,

Proof. Lemma 4.4 and N imply that

,y +

Y N,,y )+ ] = lim sup sup E[(Y

lim sup sup E[(

t
t ) ] (t, y).
N N

N N

On the other hand, for each , there

 exists a sequence
 of strategies

N
N

{N }
N =1 such that and lim E
N

|Y ,y Y N ,y |2 = 2( 2 + r2 T )E

E
t
t
4( 2 + r2 t)



(t tN )2 dt = 0. Then,

|(s

sN )

(Ys,y

N
Ys ,y )|2 ds

(s sN )2 ds
E

+4( 2 + r2 t)
0

|Ys,y YsN ,y |2 ds.

E

By Gronwalls inequality


|Y ,y Y N ,y |2 4( 2 + r2 t)E

E
t
t



0

(s

sN )2 ds

e4(

2 +r 2 t)t

0,

as N .

772

Izumi Nagayama

Lemma 4.2 implies

that for each N there exists a sequence {(N,n) n }n

(N ) ,y
(N,n) ,y

|Y
such that E
YTn,
|2 0 as n uniformly with respect
T


|Y ,y
to N . Therefore we have subsequence {(N,n(N )) }N such that E
T
n(N ),
YT

(N,n(N )) ,y

|2

Y n(N ),
0 as N . Therefore lim E[(
T

(N,n(N )) ,y

)+ ] =

,y +
N

E[(Y
T ) ]. Therefore lim inf (T, y) (T, y). 
N

5.

Closed Form of Valuation in the Case of r = 0

In this section we assume that r = 0. Then, under the measure P , we

have
t .
dYt,y = (t Yt,y )dB
Letting 1 < 2 , we derive the closed form for valuation of passport call
2 1
2 + 1
, =
and x T > 0. We consider the
option. Let
=
2
2
discrete time approximation dened in the previous section.
Lemma 5.1. For any convex function g, we have
 

sup

(1 ,2 )



E g

s dBs

= E[g(i Bt )],

where i =

2
1

if |1 | |2 |
if |1 | > |2 |.

be a Brownian motion independent of B. Then for any

Proof. Let B

 

E g
0



s dBs

 



= E g E
 

E g

0
t



s )|Ft
(s dBs + (2i s2 )1/2 dB


s )
(s dBs + (2i s2 )1/2 dB

= E [g (i Bt )] . 

Corollary 5.2.


N
E

N (m, y) =
E
N

%

m 1, y + (2 y) B
$
%

m 1, y + (1 y) B

if y

if y >
.

Pricing of Passport Option

773

Proof. This follows from Lemma 5.1 and the following.

N (m, y) =

sup

1
2

)]
N (m 1, y + ( y) B
E[

sup

y

2 y

)]. 
N (m 1, y +  B
E[

By Corollary 5.2 the optimal strategy N in the discrete framework is

inductively given by the following.


tN

1
2

N,N ,y
if Yn
>

N ,y
N,
if Yn

n t < (n + 1),

where
N
YtN, ,y = y +

= y

N
1
"

N,N ,y
N
t(n+1) B
tn )
(n
Yn
)(B

n=0
N
1
"

N,N ,y
sign Yn

%$

n=0




N,
+ Yn

N ,y

%


t(n+1) B
tn ) .
(B
N,$ be given inductively by
Let B
t
N,$ sign(Y N,N ,y
t B
n ),
N,$ = B
)(B
B
t
n
n

n < t (n + 1).

N,$ } is another P -Brownian motion and we have

Then {B
t
N
YtN, ,y = y +

N
1 $$
"

%

 N,N ,y

N,$
N,$
+ Yn

 (B
t(n+1) Btn ) .

n=0

Now let
YtN,$,y = y +

N
1 $$
"
n=0

%

 N,$,y

t(n+1) B
tn ) .
+ Yn

 (B

774

Izumi Nagayama

N
Then YtN, ,y and YtN,$,y have the same distribution and we have
N
E[(YtN, ,y )+ ] = E[(YtN,$,y )+ ]. And let Yt$,y to be the solution of the following S.D.E.

(5.1)




%


t ,
dYt$,y = + Yt$,y
 dB

Y0$,y = y.

Then we have lim E[|YTN,$,y YT$,y |2 ] = 0 by Euler-Maruyama approximaN

tion (see Kloeden and Platen [5]), and so lim E[(YTN,$,y )+ ] = E[(YT$,y )+ ].
N

$,y +
y) = E[(Y

Therefore by Proposition 4.5 we have (T,

T ) ].

Remark 5.3. From the form of N , one may guess that the optimal
strategy is given by the following.
t =

1
2

if Yt >

if Yt
,

n t < (n + 1)

where Y is given by
t ,
)( + |Yt
|)dB
dYt = sign(Yt

Y0 = y.

t + t is
For simplicity, let 1 = 1 and 2 = 1. Then recalling that Bt = B
P -Brownian motion, we see that Xt = Yt St satises
dXt = sign(Xt )dSt ,

(5.2)

X0 = y,

under the measure P . It is well known as Tanakas counter-example that

S.D.E. (5.2) does not have any strong solutions. Therefore such an adapted
process does not exist.
1$

def
Now we derive the formula for pricing the passport option. Let Yty =

Yt$,y+
. Then we have
t .
dYty = (1 + |Yty|)dB

0
t + t da,
Let f Y (y : t)dy = P [Yt0 dy] and q(a, b, t; )dadb = P [B
s + s) db]. It is well known(see Karatzas & Shreve [4]) that
min (B
0st

(a 2b t)2
2(a 2b)
exp
q(a, b, t; ) =
+ 2b .
2t
2t3

Pricing of Passport Option

775

Skorohods Theorem implies the following lemma.

Lemma 5.4.
0

f Y (y : t) =

1
(1 + |y|)2



1
log(1 + |y|) 1

+ t
2
t
t

!
1
log(1 + |y|) 1

+
.
+ t
2
2
t

Proof. We have
t + dL0 1 2 dt = dB
 + dL0 1 2 dt,
d(log(1 + |Yt0 |)) = sign(Yt0 )dB
t
t
t
2
2


 = t sign(Y 0 )dB
s . Dene a P where L0t is the local time of Y 0 at 0, and B
t
s
0
 2
dQ
def
t). Then
equivalent probability measure Q by (
)t = t = exp( B
t
8
dP
2

1

Q def 
0

Bt = Bt t is Q-Brownian motion, and we have d

log(1 + |Yt |) =
2

def 1
dBtQ + dL0t . Let Wt = log(1 + |Yt0 |). From Skorohods Theorem, we have

Wt = BtQ min BuQ (See Ikeda and Watanabe [3]). Since

0ut

Q[Wt dw, BtQ db] = q(b, b w, t, 0)dwdb



(2w b)2
2(2w b)

exp
2t
2t3

dwdb,

we have
g(w : t)

def

=
=

d
d Q
P [Wt w] =
E [I{Wt w} 1
t ]
dw
dw

w
1 2
1
d2
e 8 t 2 b
Q[Wt w, BtQ b]db
dwdb




!
1
w
1
w
1
1
w
+ t + + t
2e
,
2
t
t 2
t 2
t, w 0.

Then,
0

f Y (y : t) =

1
1
g( log(1 + |y|) : t)
2(1 + |y|)

776

Izumi Nagayama

1
(1 + |y|)2



1
log(1 + |y|) 1

+ t
2
t
t

!
1
log(1 + |y|) 1

+
.
+ t
2
2
t

Lemma 5.5.
C(T, S
, S, 1 , 2 )
 &
'

(1 + T d1 (T ))(d1 (T )) + T (d1 (T ))
=S
2

+ |
|
+
+
(d2 (T ))
2

+ |
| T
1
where d1 (T ) = log
+
and d2 (T ) = d1 (T ) T .

2
T


(Y $, )+ . Then we have
Proof. Note that C(T, S
, S, 1 , 2 ) = S E
T

(YT$, )+

=



= E

|
|

(y +
) f

Y 0

+ 

(y +
) f Y (y : T )dy

(y : T )dy + 2

|
|

f Y (y : T )dy

d1 (T ) $

YT0 +

T z+ 12 2 T

T z 12 2 T

+
e

T
(z) +
(z) dz
2

e
(z) +
(z) dz
+2
+
2
d1 (T )
'

&
=
(1 + T d1 (T ))(d1 (T )) + T (d1 (T ))
2
+ |
|
+
+
(d2 (T )). 
2

Theorem 5.6.
C(T, x, S, 1 , 2 )

T z 12 2 T

Pricing of Passport Option

T f2 (x,T )

= Se

777

f2 (x, T ) f3 (x, T ) +
T
2

S( sign(x
S)
) f2 (x, T ) f3 (x, T )
T
2

+Se

( sign(x
S)
)


T
f2 (x, T ) f3 (x, T )+
2



+
S f2 (x, T ) f3 (x, T ) +
T + x1{x<S}
2
+S
(1{>0} 1{x<S} )
 




T f2 (x,T )
T +e
f2 (x, T )
T
f2 (x, T ) +
2
2

 


2T

+S
1 T f1 (T ) +
f1 (T ) + f2 (x, T ) +
T
2
2
2


2 T (f1 (T )+f2 (x,T ))

S e
f1 (T ) + f2 (x, T )
T
4
2



2t
T x

+S
g (T t)
T)
(f1 (t) +
2 0
2
2
!

T ) dt
+ t(f1 (t) +
2


T f2 (x,T )

where
f1 (t) =

|
log +|

log 1 + 1 | Sx
|

f2 (x, t) =
t


S)

log sign(x

if sign(x
S)
>0

if sign(x
S)
0



f2 (x, t)
1
g x (t) =
f2 (x, t) + t .
t
2

f3 (x, t) =

$,x/S +
)

(Y
Proof. Note that C(T, x, S, 1 , 2 ) = S E
T

&

inf t > 0 : Yt$,y

and let y =
y

=
= inf t > 0 : Yty = 0 , where y =
. Then, we

'

&

'

778

Izumi Nagayama

have

(Y $,y )+ , T y + E
(Y $,y )+ , T < y .
(Y $,y )+ = E
E
T
T
T


And
y
dYt
y

Therefore

y
(1 + Yt
y )dBt y
y

(1 Yt y )dBt y

if y 0
if y < 0.

1
y
y ) (1 + |
y |) exp sign(
y )Bt y 2 (t y ) 1 .
Yt
y = sign(
2
Then, we have

inf{t > 0 : Bt =

y =

log(1 + y) + 12 2 t }
$

inf{t > 0 : Bt = 1 log(1 y) + 1 2 t }

2


y)
= inf t > 0 : Bt = sign(
Then


(Y $,y )+ , T < y = E

E
T



1 log(1+|
y |)



if y 0
if y < 0

1
1
log(1 + |
y |) + 2 t

YTy +

!

+

,T <

q(a, b, T ; )
2

{sign(
y )((1 + |
y |)e 1) + }+ da db

0 

! 

q(a, b, T ; ) (1 + y)ea
da db

f
b(f
+h)

if y > 0
=
! 

0 
b(f +h)

q(a, b, T ; ) (
y 1)ea +
da db

f
b

if y < 0
a

where
1
y |)
= log(1 + |


sign(
y )

1
log

h =

if sign(
y )
>0
if sign(
y )
0.

Pricing of Passport Option

779

Since



e q(a, b, T ; )da db
2

 



2
2

+
+

T
T
= e
2
2
T
T
 



2
2

+
+
e
T
T ,
2
2
T
T




ea q(a, b, T ; )da db
2

b





T
T
=
2
2
T
T
 




+
+
+e

T
T
2
2
T
T
 




+
+e
+
T
T , for ,
2
2
T
T
and

q(a, b, T ; ) = ea q(a, b, T ; ),
2
2

we have


(Y $,y )+ , T < y
E
T




f + h+
+
= ( + |y
|)
T
2
T


f + h+

( sign(
y )
)
T
2
T





f h+
sign(
y )

+
T
( + |y
|)

2
T


f h+

T
2
T



f

1{y<} y + ( +
T
y)

2
T


f

+
+
T .
2
T

780

Izumi Nagayama

Next, we have


(Y $,y )+ , T y
E
T

=
0

=
0

=
0




y
(Y $, )+ dt
g (T t)E
t

'

&
(1 + td1 (t))(d1 (t)) + t(d1 (t))
2

+ |
|
+
+
(d2 (t)) dt
2
 

2

+ |
| t
y
g (T t)
(1 log
+
)(d1 (t)) + t(d1 (t))
2

2
y

g (T t)

+
+

+ |
|
(d2 (t)) dt
2

where


log(1 + |
y |)
log(1 + |
y |) 1

+ t
2
t
t3


f
f
1
= + t .
t 2
t3

d
P [ y t] =
g (t) =
dt
def

Since

f
f

g (T t)dt = +
T + (1 + |
y |)
T
2
2
T
T
0


f
y
g (T t)(d1 (t))dt = d1 (T ) +
T


f
y
g (T t)(d2 (t))dt = (1 + |
y |) d2 (T ) +
,
T
T

we have


(Y $,y )+ , T y
E
T
 




f
f

=
+
T + (1 + |
y |)
T
2
2
T
T

 


+ |
| 2 t
f
+
1 log
d1 (T ) +
+
2

2
T
+



Pricing of Passport Option

781

|
+ |
f

(1 + |
y |) d2 (T ) +
2 2
T



T
2

y
+
g (T t)
(d1 (t)) + t(d1 (t)) dt. 
2 0
2

6.

Remarks and Numerical Calculations

We examined the functions r (t) and (r (t), t) with = 1

by numerical calculations based on Equation (3.8) and the denition
of r (t) in Proposition 3.10. Figure 1 depicts the function r (t) and its
c(1 3 c)
c2 (1 2c)
t c
+
approximation functions r0 (t) = c + 2
16(1 c)5/2
1c
!
131c3 270c2 + 168c 32
log(2)

t and r
(t) = 1
which are exam2
48(1 c)
2(t + 1)
ined in Theorem 3.14 and 3.15. Figures 2 and 3 show these approximation
errors respectively. In Figure 4, we illustrate the function (r (t), t) with its
approximation function 0 (r (t), t) =

t(1 r (t)) + r 4(t) t +

Figure 1.

32

r (t)

1r (t)

782

Izumi Nagayama

Figure 2.

Figure 3.

r (t) #
1
8

r (t) 16 (1 r (t))3/2 t t which are examined in Lemma 3.8.

Figure 5 shows approximation error.

As numerical experiences we also examined the area where the optimal
trading strategy is 1 in the discrete time framework discussed in Proposition 4.1, when 1 = 1, 2 = 1, and = 1. We calculate the value of
N by using numerical integration technique inductively. Figures 6 and 7
show the case of r = 0.35(> c) and r = 0.25(< c) respectively. The symbol in these gures indicates the points where the optimal strategy is

Pricing of Passport Option

Figure 4.

Figure 5.

783

784

Izumi Nagayama

Figure 6.

Figure 7.

1, in the coordinate (y, t) where y is the value of trading strategy divided

by the current value of the security, and t is the remaining life time of

Pricing of Passport Option

785

passport option. By numerical calculation we have r (0.075) 0.35 and

(0.35, 0.075) 0.225. The symbol in Figure 6 indicates the point
where y = 0.225 and t = 0.075.
References
[1]
[2]
[3]
[4]
[5]

Black, F. and M. Scholes, The Pricing of Options and Corporate Liabilities,

J. Political Economy 81 (1973), 637654.
Hyer, T., Lipton-Lifschitz, A. and D. Pugachevsky, Passport to Success, Risk
10 (1997), September, 127131.
Ikeda, N. and S. Watanabe, Stochastic dierential equations and diusion
processes, 2nd ed, North Holland/Kodansha, 1988.
Karatzas, I. and S. E. Shreve, Brownian Motion and Stochastic Calculus,
Springer-Verlag, 1988.
Kloden, P. E. and E. Platen, Numerical Solution of Stochastic Dierential
Equations, Springer-Verlag, 1991.
(Received May 21, 1998)
(Revised July 21, 1998)
Graduate School of Mathematical Science
The University of Tokyo
3-8-1 Komaba, Meguro-ku
Tokyo 153-8914, Japan, and
The Bank of Tokyo-Mitubishi Ltd.
Derivative and Structured Products Division
2-7-1 Marunouchi, Chiyoda-ku
Tokyo 100-0005, Japan
E-mail: izumi nagayama@btm.co.jp