| Abstract: | This study modifies the static replication approach of Derman, E., Ergener, D., and Kani, I. (1995, DEK) to hedge continuous barrier options under the Black, F. and Scholes, M. (1973) model. In the DEK method, the value of the static replication portfolio, consisting of standard options with varying maturities, matches the zero value of the barrier option at n evenly spaced time points when the stock price equals the barrier. In contrast, our modified DEK method constructs a portfolio of standard options and binary options with varying maturities to match not only the zero value but also zero theta on the barrier. Our numerical results indicate that the modified DEK approach improves performance of static hedges significantly for an up‐and‐out call option under the BS model even if the bid–ask spreads are considered. © 2010 Wiley Periodicals, Inc. Jrl Fut Mark |
