Explain why a down-and-out put is worth zero when the barrier is greater than the strike price.

Name: Problem 7, Chapter 26: Options, Futures, and Other Derivatives
Uploaded: 2020-05-27T15:21:39-08:00
Duration: 1 min 16 s
Channel: Christopher Stanley
Description: Explain why a down-and-out put is worth zero when the barrier is greater than the strike price.

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Explain why a down-and-out put is worth zero when the...

Key Concepts

Barrier Level versus Strike Price

The relationship between the barrier level and the strike price is critical in determining the option’s viability. When the barrier is set above the strike price, any movement of the asset that could potentially put the put option in-the-money (i.e., the asset falling below the strike) will almost inevitably breach the higher barrier first, triggering the knock-out feature. This means that the option is effectively precluded from ever delivering a positive payoff.

Knock-out Feature

The knock-out feature is a condition embedded in barrier options that nullifies the option if the underlying asset reaches or falls below the barrier level. In a down-and-out put, if the barrier is above the strike price, the asset's decline necessary for the option to be profitable would trigger the knock-out condition, thus ensuring the option is rendered worthless.

Down-and-out Put Options

A down-and-out put is a type of barrier option that grants the holder the right to sell the underlying asset at a specified strike price, but only if the asset’s price never falls to or below a predetermined barrier level. If the asset touches or breaches the barrier, the option is immediately terminated and becomes worthless.

Barrier Options

Barrier options are exotic derivatives whose payoff depends on whether the underlying asset’s price reaches a specific level, known as the barrier, during the option's life. These options are path-dependent, meaning that the asset’s price history directly affects whether the option remains active or becomes void.

Transcript

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