An Asian option is a type of option in which the average price of the underlying asset over a period of time dictates the payoff of the option. It is different from the American or European option as in these options, the payoff depends on the price of the underlying asset at a particular point in time. They are also known as average value options.
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Asian Call Option Payoff = max [0, average of underlying’s price – exercise price]
Suppose a trader purchases a 90-day XYZ company Asian call option for an exercise price of $40. The payoff depends on the average price of the underlying stock at the end of every 30 days. The stock price on the 30th, 60th, and 90th day is $30, $36, and $38 respectively.
Using the above formula,
The options payoff = max [0, ($35 + $41 + $45)/3 – $40]
How are they used by traders?
- Asian options are a type of exotic option used to solve specific business problems that standard options cannot. They are made by altering standard options in small ways.
- An Asian options payoff is based on the average price of the underlying asset over a period of time. Hence, they help traders to buy or sell the asset at the average price rather than the spot price.
- Traders that are exposed to underlying assets like commodities, etc for long periods of time use Asian options because of their low volatility.
- Traders tend to use Asian options when the underlying asset’s market is very volatile.
Benefits of Asian Options:
- Average price: Unlike standard options, the payoff of Asian options is based on the average price of the asset over a time period. This helps the investors to purchase or sell the asset at the average price rather than the spot price.
- Low volatility: Compared to other options, Asian options have lower volatility due to averaging process.
- Less expensive: Generally, due to the low volatility of the average price, Asian options are less expensive than standard options.
- Reduces risk of market manipulation of the underlying asset at maturity.
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Asian options are a type of exotic option that uses the average price of the underlying asset at a pre-decided time period to decide the payoff instead of the spot price. It is attractive because it generally costs less than regular American options. They are used when the market of the underlying asset is highly volatile.
Author – Abha Shetty
About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.