Asian options-Benefits and Risks
An Asian option is an option type where the payoff depends on the average price of the underlying asset over a certain period as opposed to standard options where the payoff depends on the price of the underlying asset at a specific point in time that is maturity.
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How does an Asian Option work:
There are two main types of Asian style average value options. The first of these is known as the average rate options. The value of this kind of Asian option is determined by the application of a formula that assesses the difference between the average value of the asset and the 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 structured more like a vanilla option, with the difference being that its strike price is calculated as the average value of the underlying asset throughout 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 the expiration of the contract. As with a=vanilla options, Asian style options are available as both call options and put options.
Benefits of Asian options:
Average value options are generally priced lower than their vanilla counterparts. This is large 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 the vulnerability of the option to market manipulation. Market manipulation is when misleading information or appearances is given in an attempt to create an artificial perception of value. Although this practice is prohibited, it does occur 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.
The Risk involved in Asian 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. 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. From using these options, and this factor needs to be considered when choosing the trade average value of options.
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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 protecting from market manipulation of prices are the main advantages that can be garnered by using these options.
Author – Hariharan Krishnan
About the Author – Hariharan Krishnan is currently in second year BAF and is also doing FRM part 1. He is passionate about financial markets and loves to play chess and outdoor games.
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