Glossary
All terms taken from Margrabe's Derivatives Dictionary or The Futures Trading Group
- Asian Option
- Definition: An Average Price Option (q.v.).
- Example: Some banks offer their retail customers an
equity-linked CD that repays principal, plus a form of "average return" on the
S&P 500 that amounts to an Average Price Call Option.
- Application: Some hedgers use an Asian Option as a
one-stop way to hedge the price risk of regular purchase or sale of a constant amount of a
currency or commodity.
- Pricing: One can ordinarily price an Average Price
Option satisfactorily by using an adjusted volatility and dividend yield in the
Black-Scholes-Merton pricing model. If the underlying source of risk is an exchange rate,
the price of gold or silver, a share price, or an equity index, then the "square root
of three" rule for the volatility may apply. For underlying oil price risk that rule
may not work so well.
- Risk Management: With underlying currency, precious
metal, or equity risk, one can ordinarily delta hedge an Asian Option with a single
position in the underlying. With underlying oil risk and averaging over a long period,
delta hedging an Asian Option may require hedging in oil futures contracts with several
different delivery dates.
- Comment: An Asian option is based on some average
underlying asset price or rate. They are the natural development of vanilla options to
capture path-dependence. Generally speaking, an Asian option is an option whose payoff
depends on the average price of the underlying assets during the prespecified period
within the option's lifetime and a prespecified observation frequency.
- Average Price [Call or Put]
Option
- An Option – Call or Put – whose underlying price
is an average over time of a risk factor.
- Derivative
- A contract between two parties providing for a payoff from
one party to the other determined by the price of an asset, an exchange rate, or an
interest rate.
- Exchange Rate
- The rate at which a given amount of one currency converts
to another currency. See http://www.xe.net/cgi-bin/ucc/convert
for an online currency converter.
- Exotic Option
- Any Option that is well out of the ordinary, hence not a
"Plain Vanilla" Option. The list of Exotic Options changes over time. It grows
as dealers innovate new and marvelous options, and shrinks as a jaded market grows
accustomed to products that once thrilled it.
- Geometric Average
- Geometric Average GA(n) = [(¶ for i=1 to n)ai]1/n,
i=1,2,3,...n where n is the number of observations and ai is the i'th
observation. The geometric average is not as popular as its corresponding arithmetic
average, for it is not so often used.
- Hedge
- A transaction in which an investor seeks to protect a
position or anticipated position in the spot market by using an opposite position in
derivatives.
- Payoff
- The amount of money received from a transaction at the end
of the holding period.
- Sayanora Products, Inc.
- An imaginary Japanese company that exports electronics
equipment to electronics companies throughout the world. Sayanora receives payment for its
goods in yen only.
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- Spot Rate
- Term which describes one-time open market case
transaction, where a commodity is purchased "on the spot" at current market
rates. Spot transactions are in contrast to term sales, which specify a steady supply of
product over a period of time.
- Strike Rate
- The rate at which the underlying futures contract is
bought or sold in the event an option is exercised. Also called the exercise price.
- Texas Electronics Company (TEC)
- An imaginary electronics company that imports electronics
equipment each month from a Japanese manufacturer. TEC is worried about sudden
fluctuations in the US Dollar/Japanese Yen exchange rate. A sudden appreciation of the yen
could severely affect TEC's bottom line. TEC plans to hedge its foreign exchange rate risk
by using an Asian call option.
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