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BASKET OPTION

Basket Option is an option contract whose underlying asset is a basket of equities, commodities, currencies or something else. A basket option is always a cheaper way of locking in a price for the basket compared to buying a portfolio of the options on each of the basket constituents. This is a consequence of a simple algebraic fact: for any values x1, x2, ..., xN,

        max(x1 + x2 + ... + xN, 0) <= max(x1,0) + max(x2,0) + ... + max(xN,0).

The idea is actually a deep one. It indicates that if you are any good and know how to generate money, you are better off working on your own than in a big group of professionals, where your gains will be netted against several "losers". Your lifestyle is an option on the goodness generated by your talent and skills. If running your own show, you will never be allowed to starve by the society but you can make it into millions if your output sways positive. On the other hand, in a big crowd of people much more depends on how the business is doing overall... This insight relies, of course, on the assumption of no synergies or high entry barriers.

Basket options are OTC (over-the-counter) products. There are no standard baskets. Basket options are customized by sellers (typically investment banks) for buyers (typically corporations and hedge funds).


BASKET OPTION REFERENCES

Hull, J. (2011). Options, Futures, and Other Derivatives (8th ed). Pearson / Prentice Hall.

Bjork, T. (2009). Arbitrage Theory in Continuous Time (3rd ed). Oxford University Press.

Bouzoubaa, M. (2010). Exotic Options and Hybrids: A Guide to Structuring, Pricing and Trading. Wiley.

Lipton, A. (2001). Mathematical Methods for Foreign Exchange: A Financial Engineer's Approach. World Scientific.

Nelken, I., ed (1996). The Handbook of Exotic Options: Instruments, Analysis and Applications. McGraw-Hill.

Taleb, N. (1997). Dynamic Hedging: Managing Vanilla and Exotic Options. Wiley Finance, New York.

Passarelli, D. (2008). Trading Option Greeks: How Time, Volatility, and Other Pricing Factors Drive Profit. Bloomberg Press, New York.

 

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