Watermark Options

TL;DR

This paper introduces a new class of derivatives with payoffs linked to the asset's historical maximum, solving complex optimal stopping problems with explicit value functions and characterizing their free-boundary solutions.

Contribution

It provides a novel explicit solution framework for pricing perpetual American options on derivatives with payoffs dependent on historical maxima.

Findings

Explicit solutions for value functions of the derivatives

Characterization of free-boundary functions as solutions to non-linear ODEs

Different asymptotic growth behaviors depending on parameters

Abstract

We consider a new family of derivatives whose payoffs become strictly positive when the price of their underlying asset falls relative to its historical maximum. We derive the solution to the discretionary stopping problems arising in the context of pricing their perpetual American versions by means of an explicit construction of their value functions. In particular, we fully characterise the free-boundary functions that provide the optimal stopping times of these genuinely two-dimensional problems as the unique solutions to highly non-linear first order ODEs that have the characteristics of a separatrix. The asymptotic growth of these free-boundary functions can take qualitatively different forms depending on parameter values, which is an interesting new feature.