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Lower bound on a vanilla put from digital puts

Question

You want to value a European put with strike 1515. Digital puts paying 11 if ST≤KS_T\le K are available at these prices: K=15K=15 at 0.830.83, K=12.5K=12.5 at 0.640.64, K=10K=10 at 0.420.42, K=7.5K=7.5 at 0.310.31, K=5K=5 at 0.200.20. Using a portfolio of these digitals whose payoff never exceeds the put's, what is the highest price you can guarantee for the put (the best sub-replication bound)?

Short answer

3.9253.925. Holding 2.52.5 digital puts at each strike 12.5,10,7.5,512.5,10,7.5,5 gives a staircase lying under (15−ST)+(15-S_T)^+ and touching it at each strike. Its cost is 2.5(0.64+0.42+0.31+0.20)=3.9252.5(0.64+0.42+0.31+0.20)=3.925 (using the 1515 strike as well would give the matching upper bound 5.55.5).

Adapted from QuantQuestions.io; question and answer rewritten by SelfMadeQuant.com.

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