Basket Options

Purpose

Basket options have been designed to provide portfolio managers with a cost-effective solution to managing multi-currency exposures on a consolidated basis.

Description

A basket option has all the characteristics of a standard option, except that the strike price is based on the weighted value of the component currencies, calculated in the buyer's base currency. The buyer stipulates the maturity of the option, the foreign currency amounts which make up the basket, and the strike price which is expressed in units of the base currency.

At expiry, if the total value of the component currencies in the spot market is less favourable than the strike price of the basket option the buyer would let the option lapse. If it is more favourable, the buyer would exercise the option and exchange all of the component currencies for the pre-specified amount of base currency (i.e. the strike price of the option).

A basket option can cost significantly less than multiple single currency options. The lower the correlation between the various currency pairs which make up the basket the greater the cost saving.

Typical Use

A fund manager looking to protect the total value of a basket of currencies against unfavourable currency movements.

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