Rainbow option
Encyclopedia
Rainbow option is a derivative
exposed to two or more sources of uncertainty
, as opposed to a simple option
that is exposed to one source of uncertainty, such as the price of underlying asset
. Rainbow options are usually calls or puts on the best or worst of n underlying assets, or options which pay the best or worst of n assets. The number of assets underlying the option is called the number of colours of the rainbow. The options are often considered a correlation trade since the value of the option is sensitive to the correlation between the various basket components.
Rainbow options are used, for example, to value natural resources
deposits. Such assets are exposed to two uncertainties—price
and quantity
.
Some simple options can be transformed into more complex instruments if the underlying risk model that the option reflected does not match a future reality. In particular, derivatives in the currency and mortgage markets have been subject to liquidity risk
that was not reflected in the pricing of the option when sold.
drivers for the various models. While degenerate cases have simpler solutions, the general case must be approached with Monte Carlo
methods.
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
exposed to two or more sources of uncertainty
Uncertainty
Uncertainty is a term used in subtly different ways in a number of fields, including physics, philosophy, statistics, economics, finance, insurance, psychology, sociology, engineering, and information science...
, as opposed to a simple option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
that is exposed to one source of uncertainty, such as the price of underlying asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
. Rainbow options are usually calls or puts on the best or worst of n underlying assets, or options which pay the best or worst of n assets. The number of assets underlying the option is called the number of colours of the rainbow. The options are often considered a correlation trade since the value of the option is sensitive to the correlation between the various basket components.
Rainbow options are used, for example, to value natural resources
Natural Resources
Natural Resources is a soul album released by Motown girl group Martha Reeves and the Vandellas in 1970 on the Gordy label. The album is significant for the Vietnam War ballad "I Should Be Proud" and the slow jam, "Love Guess Who"...
deposits. Such assets are exposed to two uncertainties—price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
and quantity
Quantity
Quantity is a property that can exist as a magnitude or multitude. Quantities can be compared in terms of "more" or "less" or "equal", or by assigning a numerical value in terms of a unit of measurement. Quantity is among the basic classes of things along with quality, substance, change, and relation...
.
Some simple options can be transformed into more complex instruments if the underlying risk model that the option reflected does not match a future reality. In particular, derivatives in the currency and mortgage markets have been subject to liquidity risk
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
that was not reflected in the pricing of the option when sold.
Pricing and Valuation
Rainbow options are usually priced using an appropriate industry-standard model (such as Black–Scholes) for each individual basket component, and a matrix of correlation coefficients applied to the underlying stochasticStochastic
Stochastic refers to systems whose behaviour is intrinsically non-deterministic. A stochastic process is one whose behavior is non-deterministic, in that a system's subsequent state is determined both by the process's predictable actions and by a random element. However, according to M. Kac and E...
drivers for the various models. While degenerate cases have simpler solutions, the general case must be approached with Monte Carlo
Monte Carlo option model
In mathematical finance, a Monte Carlo option model uses Monte Carlo methods to calculate the value of an option with multiple sources of uncertainty or with complicated features....
methods.
External links
- PRICING RAINBOW OPTIONS
- Rainbow Options at Global-derivatives.com
- Rainbow options Mark RubinsteinMark RubinsteinMark Edward Rubinstein is a leading financial economist and financial engineer. He is currently Professor of Finance at the Haas School of Business of the University of California, Berkeley, where he is involved in teaching courses in the , an academic program that is focused on equipping...
- Rainbow option calculator