DEFINITION of Front Fee
The front fee is the option premium paid by an investor upon the initial purchase of a compound option. A compound option is one where the underlying asset is also an option (i.e. it is an option on an option). The front fee gives the investor the right - but not the obligation - to exercise the option on the option. If exercised, another fee known as the "back fee" is payable for the underlying option. Finally, the second option may be exercised to make a transaction in the underlying asset.
BREAKING DOWN Front Fee
Compound options are used in situations where uncertainty exists regarding the requirement for risk mitigation. For example, a company may submit a bid for an overseas project. If successful, the project would generate significant revenue in a foreign currency, which may need to be hedged against exchange rate risk. A compound option would be useful in this case, because the front fee payable would be lower than the premium payable on a foreign currency option contract (which is a contingent liability in any case).
Compound options come in four configurations:
The option premium associated with the purchase of either of these 4 arrangements would be the front fee and is paid to the seller of the compound option. If and when a call on a put (for example) is exercised, the option holder will purchase a put and pay the premium for that option as the back fee.
Example of the Front Fee
An example of a front fee would be to pay $1,000 for a call on a call compound option, with the right to purchase the XYZ June 50 strike calls, when the stock is trading at $40. This is a cheaper strategy when the chances of the stock rising above $50 before June are low. The premium that would have to be paid for the June 50 calls outright would be, say, $4,500.
Typically, compounded options are not used in options on stocks or equity indexes. They are mostly used in currency or fixed income markets where firms have insecurity or uncertainty regarding the need for an option’s risk protection. Another common business application that compound options are used for is to hedge bids for business projects that may or may not be accepted.