In 1997 N. Taleb wrote about the valuation of compound options: "At the moment there is no known formula nor publicly available method to price compound options correctly (using stochastic volatility), other than a few numerical techniques ..." (N.Taleb, Dynamic Hedging, Wiley 1997). I wonder if since then the situation has changed. My main problem is that I am looking for pricing methods for compounds that allow me to price these derivatives mark-to-market. Numerical routines that are too time-consuming are therefore not feasible. Hence, two questions:1) What is state-of-the-art in pricing compound options?2) Has there been any research on practical applications of these models and their P/L performance?Thanx,Sarastro

All closed form solutions I know assume a Black-Scholes world (constant volatility). The hard question (and that's what I am asking for below) is whether there exist ansätze how to accurately model non-constant volatilities (stochastic or deterministic) in compound option pricing.

You can split this question into two parts:1. General issues with stochastic volatility. See the Technical Forum for a thread that discusses this issue exhaustively.2. Specific issues with boundary conditions of compound options under stochastic volatility. Clearly you have two different strike prices, so you need to make sure you are consistent with market skew. But this is the same issue that arises with barriers and other instruments.In summary, have a look at the stochastic vol thread on the technical forum and go from there.

There is a first quick answer coming from the following remark:If given sigma(t), there is a continuous increasing function f(t) such that sigma(f(t)) =Cste,then you can formulate the Geske theory and get a compound option formula.So this give you the first part ofthe question (deterministic vol)

There is my old article regarding compound option white paper, "Analytical Valuation of Compound Options," Yeol Cheol Seong, June 2001 at BMO Financial Group and Mr. Sean Han may use this article for his phd since IMMW, North Carolina State University, August 2001. If you want the white paper, you must contact me in person at yeol_seong@yahoo.com.

Hi,Do you know if there closed formulas for calls on down-and-out calls ?Thanks a lot