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My question might be very straight forward but I have seen both approaches being followed in practice so I am curious to see if there are arguments in favor or against each one. I am explaining my question via the following example.

Let's say we want to value a twin-win double knock-out option on a single stock X (see payoff in the picture). Essentially at maturity if the underlying has moved up or down more than 10% we gain a return but if the movement is above 25% we gain nothing.

Twin win double knock out example payoff

This payoff can be easily decomposed into the sum of two options, an up-out call option with strike at 1.1/knock-out at 1.25 and a down-out put option with strike at 0.9/knock-out at 0.75.

Approach 1: I value the options separately so i might use a Black-Scholes for each and add the results. That would mean that probably I would use a different implied vola for the two separate calculations.

Approach 2: I simulate the underlying (via MC for example) and for each path I apply the payoff function below. For that I would need to make sure that I match the relevant parts of the vola surface so I would use maybe a local vol model.

Question: People from big banks told me that that they always decompose such cases and value each component completely separately and sometimes using different models. I who do not work in a big bank :p , always used the second approach. As per my understanding the second approach is more appropriate because in such a way you can calibrate the model to the relevant products quoted in the market while with the second you have a quite different representation of the underlying (probably not matching the market quotes simultaneously)

Am I missing something very basic here?

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  • $\begingroup$ They usually do price them separately and add it up. However, note that when pricing both options, in a big bank they probably won't use BS, and will use LV most likely. Beware that for a bank most of the bread and butter is on (usually dynamic) hedging, and a LV model would be more appropiate than BS for that. $\endgroup$
    – KT8
    Jun 23, 2023 at 16:42
  • $\begingroup$ @KT8 why the banks price « separately » them when the banks dont use BS model ? For example, LV model does not provide closed form solution, we need to use MC simulation, then there is no reason to price the payoff separately $\endgroup$
    – NN2
    Jun 23, 2023 at 19:29
  • $\begingroup$ I'd say that the payoff is quite simple (only terminal value matters, no interdependence between the two payoffs as I understand it). Either approach needs to result in an almost identical result. Otherwise you must have a misspecification imho. Also, if you don't work at a big shop, you will not have quotes for knock out options available to calibrate to. $\endgroup$
    – AKdemy
    Jun 24, 2023 at 6:57

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