by Amanda Harvey
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.
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.
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.
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
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.
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.