A basket option is an option whose payoff is linked to a portfolio or "basket" of underlier values. The basket can be any weighted sum of underlier values so long as the weights are all positive. Basket options are usually cash settled. A call option on France's CAC 40 stock index is an example of a basket option. Basket options are popular for hedging foreign exchange risk. A corporation with multiple currency exposures can hedge the combined exposure less expensively by purchasing a basket option than by purchasing options on each currency individually. Basket options are often priced by treating the basket's value as a single underlier and applying standard option pricing formulas. An error is introduced by the fact that a weighted sum of lognormal random variables in not lognormal, but this is generally modest.
copyright © Glyn A. Holton, 1996, 2010 |
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