A basket option is a type of financial derivative of which the underlying asset is a “basket” of commodities, securities, and currencies. Basket options are normally settled in cash. Basket options know as Multifactor Option, their payoff depends on the performance of underliers. Basket options trade in the OTC market and therefore can be customized based on the buyer and seller’s needs.
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The basket option can efficiently hedge risk on multiple assets at the same time. In place of hedging each individual asset, the investor can control risk for the basket, or portfolio, in one transaction. As every basket is unique, these options involve two counterparties and trade in OTC. Such type of trading limits liquidity, and there is no assurance way to close the options trade ahead of expiration. If a trader wants a position, and they are not able to find a party to offset their position with, they can open another transaction that fully or partially offsets their current transaction.
How is it constructed?
- Commodities, securities, or currencies can be used in basket options.
- The basket can be any weighted sum of underlier values considering the weights are all positive.
- Basket options are settled mostly in cash.
Some examples of basket options include options on a portfolio and index options.
if they own a call on a basket of currencies, but no longer want to buy those currencies, they could buy a put option on a similar basket of currencies to net out (or mostly net out) the effects of the first option. An option on a commodities index might partially offset an option on the investor’s specific basket of commodities. An S&P 500 index option might partially offset an option based on a portfolio of blue-chip stocks. And an option on the U.S. Dollar index might partially offset an option on a basket of global currencies.
How it can be used by traders for trading:
- Basket options are used by multinational corporations to hedge against the foreign exchange risk rate. Even the investors who need to broaden their exposure to a particular region buy basket options.
- A substitute to a basket option is an index option. However, if an investor is searching for exposure to an obscure economic sector, then none of the listed index options is likely to be adequately correlated with the portfolio of interest. Thus there will be significant tracking error risk that can cost more in basket option.
- Another alternative is a multitude of individual stock options. This alternative may cost more due to transaction costs and because the implied volatility of each option has a large component of specific stock risk.
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What are the benefits?
- An option on a portfolio of assets is low priced than an option on each of the portfolios. The lesser the correlation between the various assets that make up the basket, the greater is the cost-saving.
- Baskets are available for interest rate, FX, equity, or commodity-related.
- Baskets allow its client for a balanced exposure and are less unstable to an index.
The basket option is involved just in one transaction, it often costs less than multiple single options as it saves on commissions and fees.
The disadvantage of the basket option is that there is finite liquidity for such options, so abscond before expiry may require additional offsetting of the transactions.
A basket does not always react to changes in volatility, time, and price level in a similar way as its constituent do individually.
Author- Moksha Gala
About the Author-Currently, a graduate in the field of accountancy and finance. Commerce has been a part of my life now. Exploring the available choices, finance was always distinct among them. Credits, investments, and markets were always a part of my interest. So decided to embrace finance as a career for life.