DERIVATIVES 'R US/V1N13/Geographic Options
VOLUME 1, NUMBER 13/May 29, 1995
This week's topic is geographic options, meaning options named after locations. We are all familiar with American options, which can be exercised early, and European options, which cannot be exercised early. I'm not sure anyone really knows why those names were given. Most exchange-traded options in the U. S. and Europe are American options though European options are becomingly increasingly popular, especially in the over-the- counter options markets.
Ever heard of an Asian option? This is an option in which the payoff is not based on the asset price at expiration but rather on the average price of the asset over the life of the option. This is also called an "average price option". No one really knows why they were named Asian options, but it is believed they originated in the foreign currency options markets, and with the terms "American" and "European" already taken, someone called them Asian options and it stuck.
Asian options are useful for hedging a stream of foreign cash flows when the hedger is more concerned about hedging the average exchange rate. This is actually a cheaper option. In addition, they are useful in markets that are highly concentrated and, thus, are susceptible to manipulation or temporarily distorted prices. In fact, Asian-style derivatives are very common in the oil markets.
Asian option pricing is extremely complicated because an average is normally taken arithmetically. A geometrically computed average price option is easy to model but since most people feel more comfortable with the arithmetic average (accent on third syllable), the latter is more commonly used. Numerical methods, as discussed in Volume 1, Number 9, are usually necessary to price Asian options.
By the way, a variation of the average price option is the average strike option, in which the final payoff is based on the difference between the asset price at expiration and the average price over the life of the option. The average, thus, serves as the exercise price. Also, note that an Asian option can be exercisable early, making it an "American Asian option."
Another geographic option is the Bermuda option. Now think. Where is Bermuda? It's between America and Europe. A Bermuda option is an option that lies somewhere between an American option and a European option, meaning that it has a limited early exercise feature. A Bermuda option typically exercises automatically when something happens. A good example is the cap option that the CBOE introduced a few years ago. These were money spreads that automatically paid off the difference between the two strikes when the S&P closed at the upper strike. Thus, they would exercise early but not at the discretion of the holder. Unfortunately these options did not survive but variations of them are available on the OTC market. They are variations of barrier options, a topic I'll get around to later.
Another geographic option existed briefly a few years back in Japan and was called a "Japanese option." It allowed early exercise but only on Thursday. Don't ask me why. Perhaps if we have any Japanese readers, they can enlighten us. I don't think these instruments are still around.
A couple of years ago some mathematicians invented a Russian option. I think one of the authors was Russian and exercising the right of any inventor, chose to honor the motherland. As I understand it, a Russian option is a lookback option that can be exercised early. A lookback option is an option that enables you to buy the stock at its lowest price during the option's life (a lookback call) or sell it at its highest price (a lookback put). Needless to say, this is an extremely complex instrument. If you think this sounds crazy, just repeat the words "buy low, sell high" and it should makes sense.
Finally, there is the Canadian option. Actually this is just a joke I once heard while in Canada and a bit corny but I'll tell it nonetheless. A Canadian option is an option that can be exercised only after getting it approved by the Canadian government.
If anybody knows any more geographic options, please let me know but don't just make them up on the spot. (I've been tempted to do that myself.)
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