Basket option is best suited for the portfolio managers who can handle different currencies in a more effective manner. The cost of the basket option depends on the value of the individual constituents of the basket. Basket option is regarded as an option, the payoff of which is connected to a portfolio of “underlier values” contained in a “basket”.
The basket option can be referred as the (weighted) sum total of the underliers provided the values of the underliers are positive. In other words, it can be described as an option, whose returns are largely determined by the performance of assets contained together in the basket.
It is largely dependent on the value of basket containing assets.
Features of basket option:
The Basket option is gradually gaining prominence because they are being increasingly used for hedging risks or uncertainties associated with a portfolio.
Cost wise, basket option is more economical than investing in individual constituents of the basket.
Objective of basket option:
The portfolio managers are the ones who are most benefited by opting for the basket option. It helps them to manage “multi currency exposures” in a more cost effective manner.
Example of a basket option:
Call option pertaining to France’s CAC 40 stock index exemplifies basket option.
Composition of the “basket”:
The basket option may be pertaining to foreign exchange, interest rates, commodity linked or equity.
Being based regionally, a basket option may be Latin American Equity Basket (in Latin America) or an OECD Interest Rate Basket.
Price of a basket option:
The price of the basket option is decided as per the:
The correlation, which exists between the individual components.
The volatility manifested by individual components.
Advantages of basket option:
Basket option has the following benefits:
- The basket option can be tailor-made
- Chances of loss are minimum.
- Exposure is balanced.