Basket Option (G. Zuckerman 2019, p. 225) - in the view of Gregory Zuckerman "Basket options are financial instruments whose values are pegged to the performance of a specific basket of stocks. While most options are valued based on an individual stock or financial instrument, basket options are linked to a group of shares. If these underlying stocks rise, the value of the option goes up-it's like owning the shares without actually doing so".
Characteristics of Basket Option
Basket option has a lot of characteristic qualities in comparison to other financial derivatives and also benefits that comes along with it for example (D. Qu 2016, p. 197)(N. Schofield 2017, p. 248)(R. Madhumathi 2012, p. 435):
- One of the basket option characteristics said by Dong Qu is that basket option is more worthwhile than numerous of fundamental options that is why they are often used in portfolio management. Each basket option might include: equity indices, funds, interest rate swap indices, stocks.
- Basket option is characteristic financial derivative because compositional aspects and their comparable hefts do not shift as it is when it comes to for example index option.
- R.Madhumathi in his book said that the return of basket option draws upon the way our before specified basket of underling assets conducts. Basket option might be made by acquiring various of options. Withdrawal in this uncomplicated structure is thus an addition of the any particular options payout. Additional convenience of the basket option is that it ensures more reasonable approach for international corporations when it comes to selling or obtaining a basket of few currencies for designated currency, for example, a US establishment with a branch in India and in the UK might acquire a basket option which contains pounds and rupees in exchange of United States dollar.
- It is said that benefit that comes with basket option is that within a portfolio, the all asset values will at no time fall or rise in tandem.
- As said by Dong Qu there might be situation where markets move and basket option with their financial security which is supposed to balance the basket point, do not move in the way they should.
Valuation of Basket Option
- Calculating basket options, the investor is required to acknowledge the interrelationship that exists among the elementary assets applying policies of modern portfolio theory consequently to that the danger correlated with portfolio comprising of two assets is calculated as the weighted sum of the particular dangers well-aligned with their interrelationship. So as long as the assets in the portfolio are not completely firmly correlated, the variability of our portfolio will be smaller than the weighted sum of the variabilities of the assets which comprise our portfolio.
- Assessment procedures and measurement of risk should be agreed. If the implied volatility of individual assets is used as an input to the valuation of a basket option, thereupon the disclosure to changes in the implied volatility of each constituent asset should be reflected dynamically or statically, in price-vol matrix reports and other measurements of volatility calculated for the individual assets.
Specific example of Basket Option
A different example of a basket option that you may encounter is (S. Allen 2013, p. 413):
- An Asian option on a single asset is a particular example of a basket option. An Asian option is an option on the asset's average price over a set of observations.
- Allen S. (2013), Financial Risk Management: A Practitioner's Guide To Managing Market And Credit Risk, John Wiley & Sons, New Jersey
- Baker H., Filbeck G., Harris J. (2018), Commodities: Markets, Performance, And Strategies, Oxford University Press, New York
- Hanbali H., Linders D. (2019), American-Type Basket Option Pricing: A Simple Two-Dimensional Partial Differential Equation, Quantitative Finance, p. 2-15
- Linders D., Stassen B. (2015), The Multivariate Variance Gamma Model: Basket Option Pricing And Calibration, Quantitative Finance, p. 2-60
- Madhumathi R., Ranganatham M. (2012), Derivatives And Risk Management, Pearson, India
- Qu D. (2016), Manufacturing And Managing Customer-Driven Derivatives, John Wiley & Sons, United Kingdom
- Schofield N. (2017), Equity Derivatives: Corporate And Institutional Applications, Palgrave Macmillan, United Kingdom
- Smith R. (2002), Pricing Asian And Basket Options Via Taylor Expansion, Journal of Computational Finance, no. 3, p. 2-21
- Zuckerman G. (2019), The Man Who Solved The Market: How Jim Simons Launched The Quant Revolution, Penguin Random House, New York
Author: Wiktor Woźny