Of the many types of exotic options that are available for investors, Average Rate Option or as they are also known, Asia Options are some of the most practical.
Asian options are a type of option that does not settle on a specific day, or exercise into a underlying instrument, but instead is settled on a cash basis based on the average rate of the underlying instrument over a specific period.
An Asian option has a strike price, and expiration date, a determination period, and is calculated similarly to a European or American style option. The expiration date, is the last day of the determination period which is used to calculate the value of the underlying instrument of the option. Asian options are can be customized for weekly periods, monthly periods, quarterly periods and annual periods. In fact, there is no limitation on how they can be created. Asian options on regulated exchanges, such as the Chicago Mercantile Exchange, Asian option are usually relegated to monthly options.
When purchasing a call or a put, which is an Asian option, an investor or hedger is speculating on the value of an underlying instrument over a period. For example, a Call option on WTI crude oil for the month of October, with a strike price of $80 dollar per barrel would examine the price of the prompt (first) contract of crude oil during the month of October. Each day during the month, the settlement of the prompt contract would be added to the other prices during the month. The average price at the end of the month is the price that is then used to determine if there is a payout for the option.
If the average price for October were $81 per barrel, then the owner of a Asian style call option would receive $1 dollar per barrel, times the number of options held. If the average price of crude oil during the month of October were $79 dollar a barrel, then the option would expire worthless. For a Asian style put option, with a strike of $80, an average price of $79 would create a payout of $1 dollar per barrel to the buyer of the put option, and if the price averages $81 dollars a barrel, the put option would expire worthless. For quarterly options, the determination period is a three-month period, and a annual Asian option, the determination period is an entire year.
Pricing Asian options requires an additional component that estimates the linear average of the underlying instrument. This is calculated by using the implied volatility of an Asian option. Implied volatility is how much market participants believe the market will move over a period, annualized. For Asian options, this is smoothed by the averaging period. One advantage of Asian options is that these reduce the risk of market manipulation of the underlying instrument at maturity.
So if the market is squeeze on a particular day, it should not greatly affect the overall average calculated in the determination period. Another advantage of Asian options involves the relative cost of Asian options compared to European or American options. Because of the averaging feature, Asian options reduce the volatility inherent in the option; therefore, Asian options are typically cheaper than European or American options. Averaging is broadly segregated into three categories; arithmetic average Asians, geometric average Asians and both these forms can be averaged on a weighted average basis, whereby a given weight is applied to each stock being averaged. This can be useful for attaining an average on a sample with a highly skewed sample population.
To this date, there are no known closed form analytical solutions arithmetic options, due to the a property of these options. Average rate options are priced using a number of methods, which include binomial trees, which is a form of simulation. The additional consideration, which must be made, is that at any point in time on the tree, the value of the option is dependent upon the average of the price that the path has taken.
The greater the averaging period of the Asian option, the more the volatility is smoothed, and therefore the less expensive the volatility will be. This in turn will drive premium prices down. A quarterly average will be less volatile, and therefore the implied volatility will be less than the implied volatility of a monthly Asian option. Additionally, an annual Asian option will have a smoother average, and therefore a lower volatility then a quarterly or monthly option.
Asian options are excellent tools for hedging underlying assets. Crude oil producers or Gold miners’ that produce a specific amount of product per day, can use Asian options to mimic there production and hedge their exposure. This style also works very well within the interest rate sector, the currency sector and equity indexes.