Short-term barrier option price expansion

Abstract

We derive a short-maturity expansion for up-and-out put barrier option prices under continuous stochastic volatility when the strike and the barrier approach the spot at the diffusive scale. Assuming joint weak convergence of the normalized terminal return, the relative volatility fluctuation, and the running maximum, together with uniform integrability, we show that the leading term is the time-inhomogeneous Black-Scholes barrier price fitted to the forward variance curve. The first model-dependent correction is of order $θ^{H+1/2}$, where $θ^H$, $H \in (0,1/2]$, is the order of the relative volatility fluctuation, and is represented explicitly through killed Brownian transition densities. For regular volatility models, where $H= 1/2$, the coefficient is determined by the short-maturity at-the-money implied-volatility skew. For rough volatility models with $H < 1/2$, the coefficient reduces to a one-dimensional integral. Numerical experiments show that the correction materially improves the Black-Scholes approximation.