What is it?
An Asian option (also called an average option) is an option whose payoff is linked to the average value of the underlier on a specific set of dates during the life of the option. There are two basic forms:
1. An average price option is a cash-settled option whose payoff is based on the difference between the average value of the underlier during the life of the option and a fixed strike.
2. An average strike option is a cash settled or physically settled option. It is structured like a vanilla option except that its strike is set equal to the average value of the underlier over the lifeHow is it constructed?
How is it constructed?
- Premiums are paid in advance. Due to the reduced potential for the buyer to receive a large payoff, they cost less than a corresponding vanilla option.
- Can be structured as both American and European options.
- The averaging feature can be applied throughout the entire life of the option, or for a period of time at the beginning and/or end.
When is it used?
- They were originally used in 1987 when Banker’s Trust Tokyo office used them for pricing average options on crude oil contracts; and hence the name “Asian” option.
- They are commonly traded on currencies and commodity products which have low trading volumes.
- End-users of commodities or energy related products tend to be exposed to average prices over time, so Asian options are attractive for them.
- Asian options are also popular with corporations, such as exporters, who have ongoing currency exposures.
What are the benefits?
- They tend to be less expensive—sell at lower premiums—than comparable vanilla puts or calls. This is due to their lower levels of volatility making them cheaper.
- As a rule of thumb they are generally cheaper than their European counterparts.
- The averaging feature can be applied throughout the life of the option, or at the beginning, and/ or at end, and therefore the cost of the option can be tailored to investor needs.