Bermuda Options

Bermuda Option refers to those options which can be exercised on fixed dates (which are predetermined in advance) after the completion of the lock-in period. In other words, it gives the holder of the option the right to exercise on a specific set of dates during the life of the option.

Bermuda Option is a blend of the two other popular exotic options, namely the American option and European option, and it got its name from the place Bermuda, which lies between these two places. It is also called the Mid-Atlantic Option. Thus the exercise date for such an option is restricted to certain dates, unlike American options, which can be exercised anytime, or European Option, which can be exercised only on the maturity of the option. Due to these inherent features, these options are usually priced more compared to European Option and Less compared to the American option.

• Bermuda Options are financial derivatives granting the holder the right to buy or sell an underlying asset at predetermined prices within a specified period, including specific exercise dates.
• Unlike European options, Bermuda Options allow exercise at specific intervals, providing greater flexibility to benefit from favorable price movements.
• Bermuda Options are suitable when the underlying asset's value fluctuates, allowing strategic exercise based on market conditions.
• Pricing Bermuda Options is more intricate due to multiple exercise dates, requiring advanced models like the Binomial Model or Monte Carlo simulation to determine their value while considering potential exercise decisions.

ABC limited purchased shares of Reliance Industries Limited @ $1000 per share on 01.01.2019. The company bought 20000 shares, amounting to 20 million dollars. To protect itself from any downside, ABC Limited decided to purchase Bermuda Option with an Exercise Price of $980 with a six-month expiry ending on 30.06.2019 and the option to exercise on the first date of every month for $10 per share option.

Details are as follows:

The option allows ABC Limited multiple benefits, namely:

• It provides downside protection against any price erosion below 980$.
• Provides the opportunity to sell the stock at the exercise price on the first day of every month irrespective of the price of the stock on that date (Mostly option is exercised only when it is in the money, i.e., the price is less than the strike price of $980).

Thus if the price falls below $980, ABC Limited can sell the stock on the pre-specified dates and protect itself from the further downside.

• They are less expensive compared to American Options and offer better exercising options than European options.
• These options are over the counter traded (OTC) products and offer customized trades compared to standard options which are standard.
• This type of option is mostly used in Interest rate Contracts and Forex Markets.
• These options are a good choice for companies that have to receive payments in foreign currency and have the option to receive it on some prefixed dates. In such cases, the company can be better off by buying a Bermuda Option and paying less premium compared to an American Option.

• It cannot be exercised at any time like American options and exercisable only on specified dates, which are predetermined.
• These options are expensive compared to European Options, and the buyer is better off opting for European Option if the intention is to exercise only on the expiry of the option.
• It can be exercised only on specific dates, which may not be the best days to exercise the option.
• It offers writers of such options to exercise more control over when the option can be exercised rather than on the option buyer.
• It requires the use of complex option pricing models and can’t be undertaken using the standard Black Scholes Option pricing model.

Bermuda Options acts as a mixture of American and European Options; however, what makes them more relevant and useful is that they provide specific dates on which they can be exercised before expiry and are less costly compared to American Options, which allow exercising any time on or before expiry. Thus if a trader expects movement in the underlying asset over a specified period/dates only due to any external event or event associated with the underlying asset, he/she can generate a better cost-effective return by opting for a Bermuda Option than an American option.

For instance, Traders betting on prices of Crude Oil can opt for Bermuda Option when OPEC (Oil producing and Exporting countries) meet ( which directly impacts the prices of Crude Oil) coincides with the specific dates as that can safeguard the cost rather than opting for an American option, thereby gaining from the hybrid model.

Bermuda Option is mostly Over the Counter Traded options and is often used as a hedging instrument for interest rate contracts and foreign exchange contracts. It offers more flexibility compared to European options. Such options are also used for specific situations or event-specific purposes. The writer of such options makes use of extensive quantitative techniques and sophisticated option Pricing Models to price these complex derivative instruments. These exotic options offer more flexibility compared to a European Option at the expense of additional premium and less exercising opportunities compared to the American option by being less expensive compared to American Options.

This has been a guide to Bermuda’s options and its definition. Here we discuss an example and its comparison with the American option along with advantages and disadvantages. You can learn more about financing from the following articles –

• How to Trade Options?
• Index Options
• Non-Qualified Stock Options
• European vs. American Option