Binomial Approximations for Barrier Options of Israeli Style

TL;DR

This paper demonstrates the convergence of binomial approximation methods for pricing Israeli-style barrier options in the Black-Scholes model, providing estimates of convergence speed and computational advantages.

Contribution

It extends binomial approximation techniques to game barrier options, including path-dependent payoffs, with new convergence results and computational methods.

Findings

Convergence of prices and risks in binomial models to Black-Scholes values.

Estimation of convergence speed for barrier options.

Application of dynamic programming algorithms for computation.

Abstract

We show that prices and shortfall risks of game (Israeli) barrier options in a sequence of binomial approximations of the Black--Scholes (BS) market converge to the corresponding quantities for similar game barrier options in the BS market with path dependent payoffs and the speed of convergence is estimated, as well. The results are new also for usual American style options and they are interesting from the computational point of view, as well, since in binomial markets these quantities can be obtained via dynamical programming algorithms. The paper continues the study of [11]and [7] but requires substantial additional arguments in view of pecularities of barrier options which, in particular, destroy the regularity of payoffs needed in the above papers.