What Is a Rebate Barrier Option?

A rebate barrier option is a barrier option that includes a rebate provision. These types of options offer investors a rebate based on a specified underlying asset price which is known as a barrier price. The rebates associated with barrier options are provided to investors when a barrier option is not able to be exercised.

How Rebate Barrier Options Work

Rebate barrier options are an instance of standard barrier options that include a rebate provision to investors when the option is unable to be exercised. Barrier options can be offered in two generalities and four different forms, which are explained below. All forms of barrier options can contain a provision to provide rebates, or payments, to holders if the option does not reach the barrier price and becomes worthless when it expires. Such options are known as rebate barrier options. Rebates, in such cases, take the form of a percentage of the premium paid by the holder for the option to the other counterparty.

Rebate barrier options can be complex and fall under the category of exotic options. Exotic options are known to have complex structurings that build upon the basic concepts of plain vanilla options but include non-standard terms.

Key Takeaways

  • A rebate barrier option is a type of exotic option that includes a rebate provision paid to investors if the barrier option is not able to be exercised.
  • Rebate provisions may be included in knock in (down and in; up and in) or knock out (down and out; up and out) options variations.
  • Rebates often take the form of a percentage of the premium paid by the holder for the option.

Rebate Barrier Option Variations

Like all options, barrier options give the holder the right, but not the obligation, to buy or sell a financial asset at an agreed-upon price based on their option position. Barrier option contracts are generally American options which allow the holder to exercise at any time up until the expiration. Where barrier options differ from standard options is in their barrier price which can either make the option effective or defective.

Generally, there are two broad types of barrier options known as knock in or knock out. Knock in options can be either down and in or up and in. Knock out options can be either down and out or up and out. Each of these different types of options can include a rebate provision.

Knock In

Knock in options become effective when a specified barrier price is reached or exceeded depending on the terms. When the barrier price is reached the holder has the option to exercise up until the expiration. These options could offer a rebate to the holder if the option is never activated.

  • Down and in: A down and in barrier option will become effective when a price reaches or falls below a barrier price. 
  • Up and in: An up an in barrier option will become effective when a price reaches or moves above a barrier price.
Up-and-in option example
Up-and-in option example.  Investopedia

Knock Out

Knock out options are the opposite of knock in and become defective when a barrier price is reached. When the barrier price is reached the option can no longer be exercised. These barrier options may offer a rebate to the holder if the option becomes defective.

  • Down and out: In a down-and-out option the option becomes defective when the price reaches or falls below the barrier.
  • Up and out: In an up and out option the option becomes defective when a price reaches or moves above the barrier.