Outperformance option

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.

 

 

 

One comment

  1. […] Outperformance option Exotic option definition | investopedia, Definition ‘exotic option’ option differs common american european options terms underlying asset calculation . […]

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