Basket Option

Basket Option
See also
Embedded derivative Capped Index Asset-swap spread Swap Ratio Blended Rate Bunny Bond Asset swap Risk of portfolio Interest rate differential

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

Basket option calculation method and related factors that need to be implemented by the investor (H. Baker 2018, p. 86)(S. Allen 2013, p. 411):

• 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.

Advantages of Basket Option

One of the main advantages of basket options is that they provide a diversified way of trading in the stock market. This can provide many benefits, including:

• Reduced risk exposure: By investing in basket options, a trader can balance their portfolio, reducing their risk exposure by diversifying across multiple stocks.
• Lower transaction costs: Since basket options allow for trading multiple stocks in one trade, the associated transaction costs are lower than if trading the same stocks individually.
• Increased liquidity: Basket options can also provide increased liquidity, as the underlying stocks within the basket can be more easily traded.
• Lower volatility: Basket options can also provide a lower level of volatility, as the overall performance of the basket is less affected by the performance of any single stock.

Limitations of Basket Option

Basket options have several limitations that should be considered before investing. These include:

• Limited diversification: Since basket options are linked to a specific group of stocks, they do not offer as much diversification as a portfolio of individual stocks.
• Risk of concentration: When investing in basket options, investors are exposed to the risk of the underlying stocks within the basket performing poorly, which could lead to a loss of capital.
• Lack of liquidity: Basket options may not be as liquid as other financial instruments and may be difficult to trade.
• High transaction costs: Transaction costs may be higher when trading basket options due to the complexity of the instrument.
• Unpredictable returns: Basket options can be difficult to predict, as their value is based on the performance of a group of stocks, making it difficult to accurately forecast the future performance of the option.

Other approaches related to Basket Option

The following are other approaches related to Basket Options:

• Equity-Linked Notes (ELNs): These are debt-based instruments that are linked to the performance of an equity index or individual stocks. The return on the ELN is based on the performance of the underlying stocks, and investors receive a predetermined amount of money at maturity.
• Exchange Traded Funds (ETFs): These are investment funds that track an index or basket of assets. ETFs provide investors with access to a diversified portfolio of stocks, bonds, commodities, and other financial instruments.
• Equity Index Futures: These are derivatives contracts that allow investors to speculate on the future direction of an underlying equity index. The return on the futures contract is based on the performance of the underlying index.
• Options on Equity Indices: These are options contracts that allow investors to speculate on the future direction of an underlying equity index. The return on the option is based on the performance of the underlying index.

In conclusion, Basket Options are financial instruments whose values are pegged to the performance of a specific basket of stocks. Other approaches related to Basket Options include Equity-Linked Notes, Exchange Traded Funds, Equity Index Futures, and Options on Equity Indices.

References

• 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