DEFINITION of 'Average Price Call'

An average price call is a type of exotic option where the payoff is either zero or the amount by which the average price of the asset exceeds the strike price. The average price referenced by these options is derived with a timeframe that is determined at the creation of the option - so for a three month average price call, the holder of the option would receive a positive payout if the average closing price for the underlying security traded above the strike price during the three month period.

This can be contrasted with an average price put, where the payoff is positive if the average price of the underlying security during the time frame is less than that of the strike price.

Asian options are a type of average price option.

BREAKING DOWN 'Average Price Call'

An average price call is part of the category of average priced options (APO), sometimes referred to average rate options (AROs) in interest rate markets. APO's are often traded over the counter (OTC), but some exchanges such as the intercontinental exchange (ICE) do have mechanisms to trade them as listed contracts. For listed APOs, they are cash settled and can only be exercised on the expiration day, which is the last trading day of the month.

Because of the averaging feature, average price calls reduce the volatility inherent in the option; therefore, these options are typically cheaper than European or American style options.

An example of an average price call

For example, consider global investment bank who believes that interest rates are set to decline and therefore desires to hedge its exposure to Treasury bills (T-bills). Assume that this bank seeks to hedge $1,000,000 of interest rate exposure for one month. Further assume that the relevant T-bills futures are currently trading in the market at 145.09. You establish an average price call with a strike price of 145.00 expiring in one monthm which you purchase with a net premium of $45,500.

After one month, when the option is about to expire, if the average price of T-bills futures is 146.00, the bank's profit would be $954,500 (i.e. the difference of $1 between the strike price and the average price X $1 million notional, less the net option premium paid). Alternatively, if the average price of T-bills over the one-month period was 144.20, the option would expire worthless. In this case, the bank's loss on the hedging transaction would be equal to the cost of the option premium, or $45,500.

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