Lookback option pricing
A lookback option offers the holder the right to buy a certain asset at the lowest price realized during a certain period. Therefore, thus called lookback option. In case of a put, it offers the holder to sell a certain asset at the highest price realized during a certain period. Due to the path dependent nature, the most straightforward way to price lookback options is through on Monte Carlo simulations. Important is that, lookback options have a floating strike price and as a result, always end up in the money. Therefore, lookback options tend to be more expensive.
Lookback option pricing simulation ingredients
Due to the odd payoff of lookback option, it can not be valued through an analytical formula. However they can be valued through a simulation experiment. In many simulation exercises, the geometric Brownian motion, as shown below, can be used to model the underlying stock behaviour. In this formula S equals the price of the stock, μ equals the stock’s return, σ equals the stock’s volatility and Δt equals 1 time step.
In order to implement the stock price evolution in Excel this has to be restated as follows:
With an uncertainty parameter ε generated by a certain distribution, often just a normal distribution.
Lookback option pricing simulation implementation
The value of a lookback option can in practice be determined based on the following method:
Step 1: Determine the return μ, the volatility σ, the risk free rate r, the time horizon T and the time step Δt
Step 2: Generate using the formula a price sequence
Step 3: Calculate the payoff of the lookback call and, or put and store it
Step 4: Apply step 2 and 3 N times (e.g. 10000)
Step 5: Calculate the average of all the stored payoffs
Step 6: Discount this value back to today
Lookback options of the right to buy or sell an asset at its most favorable realized price. These exotic options are more expensive and always end up in the money. Monte Carlo simulations support the lookback option pricing process.
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