The Financial Engineer

What is it?

• A call or a put option with a payoff based on the relative outperformance of one asset over another for a specified amount invested.
• Also known as exchange or spread options.

How is it constructed?

• Both European and American are available, and can be cash or physically settled. Typically they are European and cash delivered.
• Can be written on equities, bonds, and currencies.
• Can be purchased on exchanges, but is primarily traded in the OTC.
• At maturity, the percentage return of the two assets with respect to their initial price levels are observed.
• In the event the asset thought to outperform actually underperforms, the payout is zero.

Payoff = N * MAX [ ( – ) , 0 ]
Where: N = notional
AF, BF = maturity price level of assets A &
B respectively
AI, BI = initial price levels of assets A&B
respectively
Max profit: Unlimited

Max loss: Premium

When is it used?

• Useful for investors who wish to gain leveraged exposure to the performance of one asset over another with limited downside.
• Can be used by structured products traders to hedge correlation exposures.
• Essentially outperformance options rely on the correlation views of the client. If they are long the call, then they will make money out of a drop in correlation because it widens expected returns.
• Initial levels of the two indices are just as important as the final levels in order to determine the payoffs. Thus the timing of a purchase or sale is an important consideration.
• Outperformance options can be used as an alternative to equity performance swaps.

What are the benefits?

• Enables investors with more confidence to predict the relative performance than absolute levels to take a position.
• Relatively low in cost terms in relation to the magnitude of the potential upside.
• When the implied correlation between two assets are greater than +0.5, then outperformance option is cheaper than a plain vanilla call on either of the two indices.