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Down-and-out versus down-and-in call

Question

Plot against the current spot price (a) a call that pays out only if the stock never touches a barrier set below the current price, and (b) a call that pays out only if that barrier is touched. How are the two related?

Short answer

They add up to the vanilla call. The knock-out is zero at and below the barrier and rises towards the vanilla value far above it; the knock-in equals the vanilla call at the barrier and decays towards zero as spot moves far above it. Exactly one of them pays on every path, so down-and-out plus down-and-in equals the ordinary call.

Adapted from Joshi, Denson & Downes, Quant Job Interview Questions and Answers, Q2.12, p.17; question and answer rewritten by SelfMadeQuant.com.

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