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 cannot be exercised.
- 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.
Understanding Rebate Barrier Options
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 structures that build upon the basic concepts of plain vanilla options but include non-standard terms.
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: 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 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 right 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-and-in barrier option will become effective when a price reaches or moves above a barrier price.
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.