I am looking for some literature on the following issue. If you have different volatility levels for different moneyness levels implied by market traded vanilla options, what is the correct volatility level to use to price barrier options? The moneyness level can be assessed relative to the barrier or the strike price and, allthough I have an opinion, I can't find any in depth discussion on this issue.E.g.,Barrier option:Price of underlying is 199.Strike is 200.Barrier is 300.Type: Up and in.Barrier has not been triggered.As the volatility is theoretically the same at any relative level of the underlying to the strike price, I have to decide on one volatility to use in a closed form pricing formula. But there are 2 volatility levels possible: One is relative to the strike (ATM volatility) or the other, which would be an OTM volatility, relative to the barrier.Is there any literature on this?Thanks for any suggestions.Regards,e.

Your problem might be easier to solve if you break down the knock-in option into the vanilla and the one touch.Using the following Forward - {RKO Call - KNO Put} = Knock In ForwardA Knock-In forward is the same as being long and short one-touches to pay/receive the underlying/cash.You would need some sort of over-hedge rules to calibrate the theoretical price of your barrier option to the market price.

Hi, I was wondering how does one calculate 'moneyness' for different barrier options? Take your example of the barrier - what is its moneyness?Many thanks.