Finance

Bermuda Option

Bermuda Option

Certain words need to be understood before actually understanding the term Bermuda option. First, an option which means a contract that gives the investor the right but not the obligation to buy or sell an underlying financial instrument at a price which has already been decided, within a certain period of time. Secondly, exotic options are options but they differ from the traditional options in terms of payment structures, expiration date, and strike prices.

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Now the term Bermuda option can be clearly understood which is a type of exotic contract that can only be applied on predetermined dates typically on one day each month. The Bermudan option is a hybrid between the European option and the American option. This is neither American nor European and hence the name has come from the famous Bermuda triangle which also lies between America and Europe. It is less flexible than the American option. Thus, it is cheaper than the American option but costlier than the European option. Trading of Bermuda option works like any other option by making bearish or bullish trades using call option or put option.

How are they different from European/American Options?

American options are used very widely. They include call and put options. They offer the most flexible exercise schedule and can even be exercised on any trading day before their expiration. Stock options in U.S. stock markets have an expiration period ranging from three months to one year. It helps the holder of the option to gain the advantages of security or stock at any period when the security or stock is favorable. It should be noted that there is no geographic reference in relation to titles, as it applies only to the execution of options trade.

European options are the exact opposite of an American Option and they offer less flexibility hence they can’t be exercised before the expiration date. As compared to American options they are less valuable and can be usually be purchased at a discount. Lastly, they are often traded over-the-counter than on an exchange. 

Bermuda options don’t have a lot of similarities with American or European options. In this contract, specific days before expiration on which the trader can exercise his option are restricted, unlike the American Option which can be exercised at any time, or the European option, which can be exercised only at the maturity of the option. In simple words, it falls between American and European options in terms of how much freedom a trader has to exercise the option. Due to these inherent features, these options are usually priced more compared to European Options and Less compared to the American options.

Benefits of Bermuda Options:

  • Bermuda options give investors the ability to create and purchase a hybrid contract, which means more control while exercising the options. 
  • They are cheaper than American options and offer better exercising preferences than European options. 
  • These options are mostly used in interest rate contracts and Forex markets. 
  • They are counter-traded (OTC) products and offer personalized trades compared to standard options.
  • As compared to American options, premiums are much lower for Bermuda options. 

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The risk involved in Bermuda Options:

  • They can only be exercised on specified dates, which are pre-determined, unlike the American options.
  • In comparison to European options, premiums for Bermuda options are more expensive.
  • The early exercise feature doesn’t guarantee that it will be the most beneficial time to exercise.
  • They involve the use of complex pricing models and cannot be worked out using the traditional Black Scholes pricing model.

Example:

Suppose a trader purchased the stock of Company A at $100. They assume that the stock will ultimately grow and expect to hold the stock, but don’t want to risk money if the stock price falls in the short term. They buy a put option, with a strike price of $85, that expires within three months. Since there are 100 shares in each option contract, the cost of the option is either $10 or $1000. For the next 3 months, this option protects the buyer from any drop below $85. Assuming that it is a Bermuda option, and the buyer chooses to exercise the option, in other words, to sell the stock at $85 if the stock has fallen below that, they would only be able to do it on the contract’s exercise dates.

Conclusion:

Options including Bermudan are an effective investment option, considering that investors are presented with a means to minimize the risk of volatile financial markets and potentially mitigate for losses. Bermuda Option is often used as a hedging instrument for interest rate contracts and foreign exchange contracts and is mostly Over the Counter Traded options. They are used for specific situations or event-specific purposes. The writer of such options has to make use of extensive quantitative techniques and sophisticated option Pricing Models to price these complex derivative instruments.

 

Author: Mahek Medh

About the Author: Currently, I am in my second year and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance very interesting thus this is the domain and space where I wish to etch my long term career.

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