A note on the valuation of compound options

The value of a compound option, an option on an option, has been derived by Geske (1976) using Fourier integrals. This article presents two alternative proofs to derive the value of a compound option. One proof is based on the martingale approach, which provides a simple and powerful tool for valuing contingent claims. The second proof uses the expectation of a truncated bivariate normal variable. These proofs allow for an intuitive interpretation of the three elements constituting the value of a compound option. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:1103–1115, 2002