Digital Options
Pay a fixed amount when a terminal condition is met.
Read the contractual cash flows first.
Start from the payoff, fixing schedule and settlement currency. Pay a fixed amount when a terminal condition is met. The valuation method comes after the contractual exposure is unambiguous.
Pay a fixed amount when a terminal condition is met.
Express payoff and present value precisely.
Notation and units
Decimal rates and volatilities, year-fraction time and continuous compounding unless stated otherwise.
Make conventions part of the contract.
Contract dates, calendars, settlement, notionals and payoff currency are part of the valuation input.
Discounting and projection conventions must match the collateral and quotation framework.
The displayed payoff omits legal terms and lifecycle events unless stated otherwise.
“An unstated convention is a future reconciliation break.”— THEQUANTBATEMAN
Locate the quote and replication instruments.
Digital Options enters EQ valuation through its contractual cash flows, quotation and lifecycle. Scenario analysis should separate market moves from convention or settlement changes.
Map cash-flow changes into hedge risk.
Reconcile the contractual payoff before reading the EQ risk. Small date or convention changes can move cash flows before any model parameter moves.
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