Asian option

Overview

An Asian option (or average value option) is a special type of option contract. For Asian options, the payoff is determined by the average underlying price over some pre-set period of time. This is different from the case of the usual European option and American option, where the payoff of the option contract depends on the price of the underlying instrument at exercise; Asian options are thus one of the basic forms of exotic options. There are two types of Asian options: Average Price Option (fixed strike), where the strike price is predetermined and the averaging price of the underlying asset is used for payoff calculation; and Average Strike Option (floating strike), where the averaging price of the underlying asset over the duration becomes the strike price. One advantage of Asian options is that these reduce the risk of market manipulation of the underlying instrument at maturity. Another advantage of Asian options involves the relative cost of Asian options compared to European or American options. Because of the averaging feature, Asian options reduce the volatility inherent in the option; therefore, Asian options are typically cheaper than European or American options. This can be an advantage for corporations that are subject to the Financial Accounting Standards Board revised Statement No. 123, which required that corporations expense employee stock options.

Etymology

In the 1980s Mark Standish was with the London-based Bankers Trust working on fixed income derivatives and proprietary arbitrage trading. David Spaughton worked as a systems analyst in the financial markets with Bankers Trust since 1984 when the Bank of England first gave licences for banks to do foreign exchange options in the London market. In 1987 Standish and Spaughton were in Tokyo on business when "they developed the first commercially used pricing formula for options linked to the average price of crude oil." They called this exotic option the Asian option because they were in Asia.

Permutations of Asian option

There are numerous permutations of Asian option; the most basic are listed below:

Fixed strike (or average rate) Asian call payout

C ( T ) =

max

(

A ( 0 , T ) − K , 0

)

,

{\displaystyle C(T)={\text{max}}\left(A(0,T)-K,0\right),}

where A denotes the average price for the period [0, T], and K is the strike price. The equivalent put option is given by

P ( T ) =

max

(

K − A ( 0 , T ) , 0

)

.

{\displaystyle P(T)={\text{max}}\left(K-A(0,T),0\right).}

Floating strike (or floating rate) Asian call option payout

C ( T ) =

max

Types of averaging

The Average

A

{\displaystyle A}

may be obtained in many ways. Conventionally, this means an arithmetic average. In the continuous case, this is obtained by

A ( 0 , T ) =

1 T

∫

0

T

S ( t ) d t .

{\displaystyle A(0,T)={\frac {1}{T}}\int _{0}^{T}S(t)dt.}

For the case of discrete monitoring (with monitoring at the times

0 =

t

0

,

t

1

,

t

Pricing of Asian options

The pricing of Asian options is model dependent. Most work in the literature was done for case when the underlying asset follows the Black-Scholes model

d

S

t

= σ

S

t

d

W

t

+ ( r − q )

S

t

d t

{\displaystyle dS_{t}=\sigma S_{t}dW_{t}+(r-q)S_{t}dt}

. An exact result for Asian options with arithmetic averaging in this model does not exist. However, an exact result is easily obtained for Asian options with geometric averaging, see for example. Analytical approximations can be given using the method of moment matching. The simplest version matches the first two moments of the average of the asset to a log-normal distribution. This approximation is known as the Levy approximation A discussion of the problem of pricing Asian options with Monte Carlo methods is given in a paper by Kemna and Vorst. In the path integral approach to option pricing, the problem for geometric average can be solved via the Effective Classical potential of Feynman and Kleinert. Rogers and Shi solve the pricing problem with a PDE approach. A Variance Gamma model can be efficiently implemented when pricing Asian-style options. Then, using the Bondesson series representation to generate the variance gamma process can increase the computational performance of the Asian option pricer. Within jump diffusions and stochastic volatility models, the pricing problem for geometric Asian options can still be solved. For the arithmetic Asian option in Lévy models, one can rely on numerical methods or on analytic bounds. Asian options can be priced also in a short-maturity expansion, similar to the approach used for European options in the SABR volatility model. One can define an implied volatility of an Asian option

Σ

A

( K , T )

{\displaystyle \Sigma _{A}(K,T)}

European Asian call and put options with geometric averaging

We are able to derive a closed-form solution for the geometric Asian option; when used in conjunction with control variates in Monte Carlo simulations, the formula is useful for deriving fair values for the arithmetic Asian option. Define the continuous-time geometric mean

G

T

{\displaystyle G_{T}}

as:

G

T

= exp ⁡

[

1

T

∫

0

T

log ⁡ S ( t ) d t

]

{\displaystyle G_{T}=\exp \left[{1 \over {T}}\int _{0}^{T}\log S(t)dt\right]}

where the underlying

S ( t )

{\displaystyle S(t)}

Variations of Asian option

There are some variations that are sold in the over-the-counter market. For example, BNP Paribas introduced a variation, termed conditional Asian option, where the average underlying price is based on observations of prices over a pre-specified threshold. A conditional Asian put option has the payoff

max

(

K −

∫

0

T

S ( t )

I

{ S ( t ) > b }

d t

∫

0

T

I

{ S ( t ) > b }

d t

, 0

)

,