Lower bound on a vanilla put from digital puts
Question
You want to value a European put with strike . Digital puts paying if are available at these prices: at , at , at , at , at . 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
. Holding digital puts at each strike gives a staircase lying under and touching it at each strike. Its cost is (using the strike as well would give the matching upper bound ).
Adapted from QuantQuestions.io; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- Market Model and Risk-Neutral Valuation
- Option Mechanics: Calls, Puts, Moneyness, Intrinsic Value, and Exchange vs. OTC Markets
- Option Trading Strategies: Spreads, Combinations, and Payoff Engineering
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