Value Average Price Option Strips Here Problem: An oil-consuming client needs to buy oil in the future and needs to protect against a future rise in the price of oil, whilst still being able to benefit from a future drop. Solution: The client asks a bank to enter an Average Price Option Strip, in which the bank pays periodically to the client any rise of the price of oil F over an Exercise Price (aka Strike) K. For each period, the price of oil F is the average of daily observations of the Front Future Contract's price during the period's duration (a month in general). The pay-off for each period is therefore: “If F > K then the bank pays F – K, otherwise the bank pays zero.” The client receiving such a pay-off is said to be long a strip of Call Options. The Premium due by the client for the strip can be either paid upfront or paid over the duration of the Options Strip under the form of a fixed coupon C per period, so that, at each period, the net cash flow is: “If F > K then the bank pays F – K. The client always pays C.” Variations on the problem and on the solution: The client may be an oil producer instead of an oil consumer and therefore in need to protect against a drop in the price of oil, whilst still being able to benefit from a rise. The client may then buy Put Options and the pay-off at each period is: “If F < K then the bank pays K – F, otherwise the bank pays zero.” The client may be an non-oil-based energy producer, whose net revenue is positively correlated with the price of oil. In that latter case, the client may opt for selling Call options to monetise future profits now. In this case, the pay-off at each period is: “If F > K then the client pays F – K, otherwise the client pays zero.” The Premium for the calls sold by the client can be used to subsidise preferential terms on a loan taken by the client, or else to boost the coupon served by a fixed rate investment taken by the client. The client may also be an investor holding the view that the price of oil will rise over a level H in the future and will not drop below a level L. The client may therefore elect to subsidise her purchase of Call Options with the sale of Put Options. The resulting position is called a Risk Reversal, in which the pay-off at each period is: “If F > H, then the bank pays F – H The client holding the reverse view can sell (aka 'short') the Risk Reversal rather than buying it. The levels H and L may be chosen so that the Premiums of the Call Options purchased and the Premiums of the Put options sold cancel out, to form a self-financing structure. Example Term Sheet And Valuation: Deal : a monthly sequence of Options (Calls or Puts) on the arithmetic average of daily observations of the front Futures contract in the underlying commodity (i.e., oil in our example). Daily Observations are made on each business day of the period month. Each period is cash-settled in the numeraire currency (i.e., the USD in our example) on the business day immediately following the last business day of the period month. Terms :
Schedule Table :
Valuation Notes: the Value of a USD 1.00 Annuity can be
used to determine the coupon payable at each period to spread the
premium over the life of the deal. The periodic coupon is just the
Value of the Strip divided by the Value of a USD 1.00
Annuity. In the specific case of oil, averaging observations made over a month span two successive Future contracts, since the last trading day for oil futures contract is around the 16th of each month. Successive contract prices are well correlated for far out contracts, but not for upcoming ones (in one or two months). This has pricing / position management implications that must be considered by oil options market makers and traders. the log-normal volatility of the average is implied from the Asian option's price. © Reference Derivatives 2011 |
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