What Is a Basket Option?
A basket option is a type of financial derivative where the underlying asset is a group, or basket, of commodities, securities, or currencies. As with other options, a basket option gives the holder the right, but not the obligation, to buy or sell the basket at a specific price, on or before a certain date.
This exotic option has all the characteristics of a standard option, but with strike prices based on the weighted values of its components. Currency baskets are the most popular type of basket option, and they will settle in the holder's home currency.
Because it involves just one transaction, a basket option often costs less than multiple single options as it saves on commissions and fees.
- A basket option is an option where the underlying is a basket or group of any asset desired.
- Basket options trade OTC, and are therefore customized based on the buyer's and seller's needs.
- Basket options reduce trading fees, since it is one transaction instead of having to take individual trades on every position in the basket.
- The downside of the basket option is that there is limited liquidity for such options, so getting out before expiry may require additional offsetting transactions.
Understanding the Basket Option
A currency basket option provides a more cost-effective method for multinational corporations (MNCs) to manage multi-currency exposures on a consolidated basis. For example, a global corporation such as McDonald's (MCD) might buy a basket option involving Indian rupees, British pounds, euros, and Canadian dollars in exchange for U.S. dollars.
Technically, an equity index option is a basket option because the underlying asset is a weighted basket of component stocks. However, because the index is a standardized basket where a third party calculates and maintains it, index options trade similar to individual options and are not considered exotic options.
Therefore, a basket option typically refers to an option upon which a basket is created by the seller of the option, often at the request and in concert with the buyer's requirements. This is possible because basket options often trade over-the-counter (OTC), and are therefore customizable based on the buyer's and seller's needs.
Characteristics of Basket Options
The most important feature of a basket option is its ability to efficiently hedge risk on multiple assets at the same time. Rather than hedging each individual asset, the investor can manage risk for the basket, or portfolio, in one transaction. The benefits of a single transaction can be great, especially when avoiding the costs associated with hedging each and every component of the basket or portfolio.
Since each basket is unique, these options involve two counterparties and trade over-the-counter. This type of trading limits liquidity, and there is not a guaranteed way to close the options trade ahead of expiration. If a trader did want out of the position, and they couldn't find another party to offset their position with, they could open another transaction that fully or partially offsets their current transaction.
For example, if they own a call on a basket of currencies, but no longer want to buy those currencies, they could buy a put option on a similar basket of currencies to net out (or mostly net out) the effects of the first option. An option on a commodities index might partially offset an option on the investor's specific basket of commodities. An S&P 500 index option might partially offset an option based on a portfolio of blue chip stocks. And an option on the U.S. Dollar index might partially offset an option on a basket of global currencies.
A problem for basket option pricing is that a basket or portfolio does not react in the same way its individual components do. This makes sense because investors often structure diversified portfolios so that component assets do not correlate. Therefore, a basket may not necessarily react to changes in volatility, time, and price level in the same way as its components do individually.
A rainbow option is a similar type of derivative that uses multiple underlying assets. However, unlike a basket option, all the assets underlying a rainbow option must move in the intended direction. Alternatively, a rainbow option's payoff may be based on the best or worst performing asset in the basket rather than the basket as a whole.
Example of a Currency Basket Option
Assume that an international US-based company wants to buy a basket option on the Canadian and Australian dollar versus the US dollar. If the Canadian and Australian dollars drop against the US dollar they want to be able to sell them at a specified price so as to avoid further deterioration. In this case, they will buy a put with a basket containing the CAD/USD and the AUD/USD.
Assume the company knows they have more exposure to CAD and AUD, therefore they opt for a weight of 60/40. Based on current rates, at the time of the transaction, an index value can be created.
- Assume the CAD/USD rate is 0.76, and the AUD/USD rate is 0.69.
- The index value is: (0.76 x 0.6) + (0.69 x 0.4) = 0.456 + 0.276 = 0.732
Assume the buyer of the put wants a strike price at 0.72 for the basket, and the option will expire in one year. The buyer and seller will determine the amount of the contract—how much currency the option is for—as well as agree on a premium.
Assume the CAD and AUD rise, and over the next year the index pushes to 0.75. In this case, the option expires worthless because the basket index value is above the 0.72 strike price. The buyer of the put basket option loses their premium, and the seller keeps the premium as profit.
Now, assume the CAD and/or AUD fall to 0.73 and 0.65. The new index value is 0.698 ((0.73 x 0.6) + (0.65 x 0.4)). In this case, the buyer will exercise the put option to be able to sell the basket at 0.72, since the weighted value of the currencies is only 0.698.
The difference between the strike price and the weighted value, less the premium, is the buyer's profit. The seller's loss is the weighted value minus the strike price, plus the premium received.