Asian Option

Asian options are a type of financial derivative that derive their value from the average price of the underlying asset over a period of time rather than just the spot price at expiration. Its purpose is to allow investors to hedge against or speculate on an asset's average price volatility over time.

Asian options are useful in situations where the price of an asset is volatile and difficult to predict, making it challenging to make accurate predictions about future prices. Using the average asset price over a longer period, the financial instrument can help investors hedge their risks better and reduce their exposure to price fluctuations.

• Asian options are special types whose payoff is determined by an average price of the underlying asset over a specified period rather than the price just at the maturity date.
• They are particularly useful in high-volatility markets.
• Traders with sufficient experience can use it to hedge against price risk in different market scenarios, potentially making them more advantageous than European options.
• Its advantages include lower volatility than traditional options, while disadvantages include reduced flexibility and potentially lower payouts due to their averaging mechanism.

Asian options, a path-based exotic option type first traded in Tokyo in 1987, were popular in commodity trading. Exotic derivatives use an averaging procedure to calculate the payoff. It generally works as the stock's average value is computed over the options' life and compared to its strike price at the execution time.

Geometrical and arithmetical averaged options are traded in over-the-counter markets, but the latter is more common for calculation. The option type has garnered popularity because of its average mechanism regarding price determination and the minimization of the price manipulation's risk close to option maturity.

The Asian option pricing helps traders hedge exposure in small commodity and currency markets. They enable a trader to buy or sell the underlying asset at the average price instead of the spot price. This particular trait also results in cheaper option premiums. The volatility model selection is highly relevant to pricing accuracy with such option types. The accuracy of different models can be analyzed in historical data.

Typically, the first volatility predictions are created to offer options at a price, and then the models are re-run with the true underlying parameters. The estimation objective is to point out significant errors in pricing. Though many procedures have been developed, the Monte Carlo Simulation remains a benchmark in all of them. Moreover, corporate financiers like Asian options because of their low cost.

There are two types of it - Asian in and Asian out options and the latter is when the average is calculated to derive the strike price. Therefore the "Asian out" option pays the difference between the observation date average and the strike price. In contrast, the "Asian in" option is known to pay the difference between the expiry price and the floating strike.

Let's look into some examples to understand the concept better:

Example #1

Mathew bought a call option on a particular stock 1st of February with a price of $45. The average is based on the stock's value after every 30 days. For example, if the stock price after 30 days was $54, and after 60 days, it was $63, and after 90 days, it was $72.

The arithmetic mean = (54 + 63 + 72) / 3 = $63

So, Mathew's profit will equal the difference between the average and strike price.

63 - 45 = $18

It is a simple example; if Mathew's average price had been less than the strike price, the loss would have been limited to the call options premium.

Example #2

Entities in the baking industry often purchase Asian options to hedge against the volatility of wheat prices. For example, ABC Corp. may purchase an Asian out option on wheat with a strike price of $6 per bushel and an expiration date of six months. The underlying asset is wheat, currently trading at $7 per bushel.

The Asian out option calculates the payoff based on the average price of wheat up until the expiration date. For instance, if the average price of wheat during the option's life is $6.50 per bushel and wheat at expiration is $8 per bushel, ABC Corp. will receive a $5,000 ($0.50 per bushel x 10,000 bushels).

Note: The payout for the option is calculated by multiplying the payout per bushel ($0.50) by the number of bushels covered by the option (10,000).

In the case of unfavorable price movements, if the average price of wheat had been less than the strike price, ABC Corp. would have only lost the premium paid for the options contract. Overall, the instrument allowed ABC Corp. to hedge against potential losses due to price movements in the wheat market and benefit from favorable price movements.

Advantages:

• They can provide a cheaper alternative to traditional options, as their payoff is based on the average price of the underlying asset rather than the spot price at maturity.
• They can help mitigate the risk of price fluctuations, as the averaging mechanism reduces the impact of sudden spikes or drops in the underlying asset's price.
• They can be useful in markets with inefficient pricing or when the underlying asset has limited liquidity.
• They can be customized to suit the specific needs of traders and investors.

Disadvantages:

• They can be complex to price and value accurately, requiring advanced mathematical models and simulation techniques.
• They may be less liquid than traditional options, making them more difficult to trade and sell.
• They can be subject to market manipulation, as traders may attempt to influence the average price of the underlying asset to their advantage.
• They may require expertise and experience in the underlying asset or market to use effectively.

• Asian options use an average pricing method based on the asset's price over a specific period, but European options use the spot price at a specific time for the payoff.
• Asian options have multiple observation dates, while European options have a single expiration date, typically maturity.
• Asian options are considered exotic, while European options are called plain vanilla options.
• The cost of an Asian option is lower than that of a European option, as it offers protection against extreme price fluctuations. In addition, European options can be exercised before the expiration date, while Asian options can only be exercised at the expiration date.

This has been a guide to what is Asian Option. We explain the topic with its examples, comparison with European options, advantages, and disadvantages. You can learn more about from the following articles –

• Collar Options Strategy
• LEAPS Options
• Non-Qualified Stock Options