Option Types - Basket Options

Purpose

Basket options have been designed to provide portfolio managers and corporations managing a set of exposures in different currencies with a cost-effective solution for managing multi-currency risk on a consolidated hedge basis.

Description

A basket option has all the characteristics of a vanilla option, except that the strike price is based on the weighted value of the component currencies, calculated in the option’s base currency. The customer stipulates the expiration date of the option, the base currency, 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 amount-weighted value of the component currencies prevailing in the spot market is less favourable than the strike price of the basket option, the buyer would let the option expire worthless. If the total value 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) or sell the option back to cash-settle the basket option and just receive its net value.

A basket option generally costs significantly less than purchasing multiple single currency options, and the discount depends on the correlations between component currency movements. The lower the correlation among movements observed between the various currency pairs which make up the basket, the greater the cost saving by insuring the portfolio as a whole since movements in those currencies would tend to cancel each other out.

Typical Use for Hedging

  • A fund manager looking to protect the total value of a basket of currencies against unfavourable currency movements.
  • A corporation with multiple currency exposures can protect their combined exposure with a basket option at a lower overall price compared with hedging using individual purchased options.

Basket Option Example

Exposure

Consider the example of a U.S.-based fund management company who is looking to hedge a multi-currency portfolio of stocks back into U.S. dollars over the coming financial year. They have approximately 1 million dollars invested per country, and specifically, this amounts to 90,000,000 Yen invested in Japanese stocks, 606,000 Pounds in U.K. stocks, 1,050,000 Canadian Dollars in Canadian stocks and 1,086,900 Australian Dollars in Australian stocks, for a total of 4 million U.S. dollars. In this example, the spot rate for USD/JPY is 90.00, for GBP/USD is 1.6500 (or 0.6060 USD/GBP), for USD/CAD is 1.0500 and for AUD/USD is 0.9200 (or 1.0869 USD/AUD).

Market View

The fund manager favours appreciation in all of the currencies in their basket versus the U.S. Dollar, but wants to protect against a drop in the basket of currencies relative to the USD.  

Possible Solution

The fund management company could purchase USD 4,000,000 of a basket Put/USD Call option struck at the current spot rate for the basket and expiring in one year’s time with weights determined by the current currency amounts in the portfolio.  This would cost 2.30% of the USD amount or $92,000 which represents a considerable cost savings over purchasing four individual options to protect the exposure in each currency.

Outcome

  1. If the basket value observed on the date of expiry is greater than its strike price set at the current spot rates, then the basket put option expires worthless and the fund manager will enjoy the expected currency appreciation.
  2. If the basket value at expiration is less than its strike price set at the current spot rates, the basket put will be cash-settled at expiration.  This gain will help offset any losses due to currency movements incurred by the fund management company in translating its currency-denominated portfolio back into U.S. Dollars.
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