The Asian Option

by Amanda Harvey

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Introduction

An Asian option, otherwise known as an average value option, is one type of exotic option, which means that it is more complex in its structure and features than a standard or ‘vanilla’ option. As the name ‘average value’ implies, the payout of this option is determined by the average value of the underlying asset, calculated at a pre-determined set of dates. These dates, which occur throughout the duration of the contract, are called ‘fixings’. Many Asian style options are traded Over-the-Counter (OTC) rather than on an exchange.  


Payout and Structure of Asian Style Options

There are actually two main types of Asian style average value options. The first of these is known as the average rate option. The value of this kind of Asian option is determined by the application of a formula which assesses the difference between the average value of the asset and a fixed strike price. These options are cash settled, meaning that the payout which has been calculated is paid in cash to the contract holder on expiration.

The other form of average value option is called an average strike option. This type of exotic option is actually structured more like a vanilla option, with the difference being that its strike price is calculated as the average value of the underlying asset over the duration of the contract. The average strike option can be settled in cash, or may be exercised by purchasing the underlying asset at the strike price on expiration of the contract.

Generally, average value options are structured with a European expiration, meaning that they may only be exercised at expiration; however, early exercise stipulation may sometimes be arranged.

As with vanilla options, Asian style options are available as both call options and put options.

Benefits of the Asian Option

Average value options are generally priced lower than their vanilla counterparts. This is largely because the averaging of value lowers the impact of volatility, which is a key option pricing criteria.

One of the main benefits of the average value option is that it reduces vulnerability of the option to market manipulation. Market manipulation is when misleading information or appearance is given in an attempt to create an artificial perception of value. Although this practice is prohibited, it does occur, but it is much more likely to have an effect on the value at a certain date, rather than the average value over a period of time. With an Asian option, the decreased importance of the closing price of the asset at expiration acts as a form of protection from any unusual circumstances.

Average value options can be of benefit to those involved in the commodities market; especially in the case of businesses with an ongoing requirement for a specific commodity. Using these options can help to hedge against fluctuations in the market price, allowing access to the commodity at a more regulated price.

Potential Downside of Asian Style Options

Due to the smoothing effect that averaging of value creates, using the Asian option means that a trader will not have the opportunity to capitalize on the peak moments that can be created by volatility in price. This may translate into lower potential profit from using these options, and this factor needs to be considered when choosing to trade average value options.

While a vanilla option may increase dramatically in value with a spike in the price of the underlying asset, the average value option will experience much less of an effect, if any effect at all. Although this aspect is taken into account with the typically lower pricing of Asian style options, for many traders of options, volatility is what the whole game is based on, so using these average value options is not appealing to everyone.

Conclusion

The Asian option, or average value option, is classed as an exotic option, and as such, is designed to meet certain requirements that a trader may have. A typically lower cost, hedging against price fluctuations and protection from market manipulation of prices are the main advantages that can be garnered by using these options. These can be counterbalanced however, by potentially lower profit, so it is important to consider whether trading Asian style options meets the goals and criterion of a trader’s style and strategy.


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