Compound Option

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Compound Option</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"> <p class="word_list"> <a href="#compound option">compound option</a><p class="word_list"> <a href="#extendible options">extendible option</a><p class="word_list"> <a href="#holder extendible">holder extendible option</a><p class="word_list"> <a href="#writer extendible">writer extendible option</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p>A <b><a name="compound option">compound option</a></b> is an <a href="../articles/option.htm">option</a> on an option. In the simplest incarnation, compound options take four basic forms:</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/option.htm">call</a> on a call,<p class="bullet"> <img border="0" src="../images/bullet.gif" width="20" height="10">call on a <a href="../articles/option.htm">put</a>,<p class="bullet"> <img border="0" src="../images/bullet.gif" width="20" height="10">put on a call,<p class="bullet"> <img border="0" src="../images/bullet.gif" width="20" height="10">put on a put.<p>They are specified with two <a href="../articles/option.htm">strike prices</a> and two <a href="../articles/option.htm">expiration dates</a>—one of each for the compound option and one of each for the <a href="../articles/derivative_instrument.htm">underlying</a> option. There are two possible option <a href="../articles/time_value_and_intrinsic_value.htm">premiums</a>. One is paid up front for the compound option. The other is paid for the underlying option in the event that the compound option is exercised. Generally, the premium for the compound option is modest. However, if the compound option is exercised, the combined premiums will exceed what would have been the premium for purchasing the underlying option outright at the start.</p> <p>Compound option values are extremely sensitive to the <a href="../articles/volatility.htm">volatility</a> of volatility. Analytic formulas by Geske (<a href="#Geske">1979</a>), Hodges and Selby (<a href="#Hodges">1987</a>) and Rubinstein (<a href="#Rubinstein">1991</a>) incorporate the <a href="../articles/option_pricing_theory.htm">Black-Scholes</a> assumption of constant volatility, so they tend to significantly undervalue the options. Research into pricing methodologies is ongoing.</p> <p>Compound options are also bundled with <a href="../articles/option.htm">vanilla options</a>, allowing for the option to be extended beyond its original expiration date. Two forms of such <b><a name="extendible options">extendible options</a></b> are: </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table6"> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="holder extendible">holder extendible</a></b> options grant the holder the right to pay an additional premium at the option's original expiration in order to postpone the expiration date.<p class="bullet_line_space"> <img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="writer extendible">writer extendible</a></b> options extend automatically at the original expiration date if some condition, such as the option being <a href="../articles/time_value_and_intrinsic_value.htm">out-of-the-money</a>, is met. No additional premium is paid at the time of extension.<p>With either form, the extended option may have different provisions, such as a different strike, from the original option.</p> <p>Analytic formulas for pricing extendible options are presented by Longstaff (<a href="#Longstaff">1990</a>). See also the treatment in Haug (<a target="_blank" href="http://www.riskbook.com/link/haug_e_(1997).htm">1997</a>). These formulas also incorporate a constant volatility assumption, so they tend to undervalue the options.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table7"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table8"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/chooser_option.htm">chooser option</a> A derivative that converts to a vanilla put or a vanilla call at the holder's choice.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/derivative_instrument.htm">d</a></strong><a href="../articles/derivative_instrument.htm"><strong style="font-weight: 400">erivative instrument</strong></a><strong style="font-weight: 400"> An instrument which derives its value from the value of other financial instruments. Article includes a list of vanilla and exotic derivatives.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/option_pricing_theory.htm">option pricing theory</a> The body of financial theory used by financial engineers to value options and other derivative instruments.</strong></td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_1.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; margin-bottom:2"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I1"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82436"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82436;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%"> <p class="explanatory_text">Haug (<a target="_blank" href="http://www.riskbook.com/link/haug_e_(1997).htm">1997</a>) and Bryis et al (<a target="_blank" href="http://www.riskbook.com/link/briys_et_al_(1998).htm">1998</a>) describes classic pricing methodologies. 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The valuation of compound options, <i>Journal of financial economics</i>, 7, 63-81. </p> <p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15"><a name="Hodges">Hodges</a>, S. D. and M. J. P Selby (1987). On the evaluation of compound options, Management Science, 33 (3), 347-355.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15"><a name="Rubinstein">Rubinstein</a>, Mark (1991). Double Trouble, <i>Risk</i>, 5 (1), 73. </p> <p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15"><a name="Longstaff">Longstaff</a>, F. A. (1990). Pricing options with extendible maturities: analysis and applications, <i>Journal of Finance</i>, 45 (3), 935-957.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_2.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table>  <p align="center"><map name="FPMap0_I1"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap0_I1" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm">Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" href="http://www.contingencyanalysis.com">http://www.contingencyanalysis.com</a></span><br> glossary direct link: <span class="verdana10"> <a target="_top" href="http://www.riskglossary.com">http://www.riskglossary.com</a></span><br> copyright © Contingency Analysis, 1996 - current</p> <p align="center"><map name="FPMap1_I1"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map><img border="0" src="../images/logo_glossary_white.gif" usemap="#FPMap1_I1" width="241" height="89"></p> </td> <td>  </td> </tr> </table> </div> </body>