FX barriers with smile dynamics

Our mandate in this work has been to isolate the features of smile consistent models that are most relevant to the pricing of barrier options. We consider the two classical approaches of stochastic and (parametric) local volatility. Although neither has been particularly successful in practice their differing qualitative features serve our exposition. By constructing approximate static hedges we are able to closely mimic their prices. The only information we require from the models, other than the initial vanilla market to which they are calibrated, is their conditional forward smile along the barrier. This strongly supports the fact that realistic forward smile dynamics are of paramount importance when assessing a model to be used in pricing barrier options. (joint work with Glyn Baker and Reimer Beneder)