Finance

What is an Asian option, and why are they exotic?

An Asian option is a type of exotic financial derivative that gives the holder the right, but not the obligation, to purchase or sell an underlying asset at a set price on or before a specified date. The underlying asset can be stocks and commodities, currency pairs, and interest rates.

Asian options are called “exotic” because they are not as widely traded as their more common counterparts, such as European options; browse this site for more info. They are also less well-understood by investors and therefore considered to be riskier. However, Asian options can offer certain advantages over other options, such as higher payouts and greater flexibility regarding when and how the option can be exercised.

Why are Asian options not widely traded?

Difficult to price

One of the main reasons Asian options are not as widely traded as other options is because they are more difficult to price. Asian options involve a continuous averaging of the underlying asset’s price over the option’s life, rather than a single price at expiration like European options. As a result, pricing an Asian option requires complex mathematical models that consider the expected volatility of the underlying asset’s price.

Considered riskier

Another reason why Asian options are considered to be riskier is because they are often used in conjunction with other exotic derivatives, such as barrier options and lookback options. These combinations can create “path-dependent” payouts that are very difficult to predict. Path-dependent payouts depend on the order in which the underlying asset’s price hits certain predetermined levels (called “barriers”). Lookback options are another exotic option that can be used with Asian options.

Less well-understood

Asian options are also less well-understood by investors than other options.

Limited trading history

Unlike European options, which have been traded for centuries, Asian options only emerged in the early 1990s. As a result, less data is available on how these options behave over time, making it more difficult to predict their future movements.

Requires specialised knowledge

Trading Asian options require specialised knowledge of the underlying asset’s price behaviour. It is because the option’s payout will depend on the average price of the underlying asset over the life of the option.

Pricing models are complex.

As mentioned previously, Asian options are more difficult to price than other types of options. The option’s payout is based on the average price of the underlying asset over the life of the option rather than a single price at expiration. As a result, pricing an Asian option requires complex mathematical models that consider the expected volatility of the underlying asset’s price.

Higher payouts

Despite being riskier, Asian options can offer higher payouts than other types of options. The continuous averaging of the underlying asset’s price over the option’s life can lead to a “smoothing” effect, which reduces the impact of short-term fluctuations. As a result, investors can receive higher payouts from Asian options than from other types of options.

Greater flexibility

Asian options also offer greater flexibility regarding when and how they can be exercised. Asian options can be exercised during the option’s life. It gives investors more control over when they receive their payout. In addition, Asian options can be settled in cash or shares of the underlying asset. It allows investors to choose the settlement method that best suits their needs.

Used in hedging strategies

Asian options are often used in hedging strategies due to their ability to reduce the impact of short-term price fluctuations. By hedging with an Asian option, investors can protect their portfolios from sudden changes in the underlying asset price.

Suitable for long-term investments

Asian options are also well-suited for long-term investment strategies. The continuous averaging of the underlying asset’s price over the option’s life can lead to a “smoothing” effect, which reduces the impact of short-term fluctuations. As a result, investors planning to hold onto their assets for an extended period can use Asian options to reduce the risk of short-term price movements.

 

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