Equity Derivatives and Structured Products Glossary: Average option


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Average option

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Average option

Average option

A plain Vanilla option pays out the difference between its predetermined Strike Price and the Spot rate (or price) of the Underlying at the time of expiry. The purchaser of an average Option (average price, average strike, average hybrid, average ratio), on the other hand, Will receive a pay-out which depends on the average value of the Underlying. The average can be calculated in a number of ways (arithmetic or geometric, weighted or simple) from the Spot rate on a predetermined series of dates. An average rate (or average price) Option is a Cash-settled Option with a predetermined (ie fixed) strike which is exercised at expiry against the average value of the Underlying over the specified dates. In general, Hedging with an average Option is cheaper than using a Portfolio of vanilla options, since the averaging process offsets High values with Low ones and therefore lowers Volatility and Premium. Average options, also known as Asian options, are particularly popular in the Equity, Currency and commodity markets. In contrast, the strike for an average strike Option is not fixed until the end of the averaging period which is typically much before the expiry. When the strike is set, the Option is exercised against the prevailing Spot rate. Unlike average price options, average strike options may be either Cash or physically settled. In the case of an average hybrid Option (also known as an average-in/average-out Option), both the strike and Settlement Price of the Option are determined using the average, where the strike averaging period typically precedes the Settlement Price averaging period. For the average ratio Option, both the strike and Settlement Price of the Option are determined using the average as in the hybrid case.The final payout is determined by comparing the ratio of Settlement Price to strike and a fixed percent strike.

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