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Asian Options

The payoff of an Asian style option (or average price option) depends on the difference between the average price of the underlying asset over a certain time period, and the strike price. Such options allow the investor to buy or sell the underlying asset at the average price instead of at the spot price. They are prevalent in commodity markets where a party may have regular and ongoing transactions in a particular underlying asset and hence a desire to hedge itself against price fluctuations. Asian options are also used in situations where the purchaser wants to cover many spot transactions using only one hedging instrument or in situations where it is prudent to reduce the dependence of an option on the spot price of the underlying on a single date. In general (but not always), Asian options are less expensive than their European counterparts, since the volatility of the average price will be less than the volatility of the spot price.

As an example, consider regular consumers of crude oil whose supply price is not fixed, but is set weekly from a particular benchmark. They are concerned that there may be a spike in oil prices over the next few months and want to hedge themselves using options. They require that the payoff of the hedge reflects the weekly purchases made over a specified time period. An Asian style option can be tailored to meet this requirement through the use of weekly price fixings over the applicable period. The option captures changes in the commodity over the averaging period and is significantly less expensive than the alternative of purchasing a basket of European options each maturing on a given fixing date. Most Asian style options use an arithmetic average and sample at discrete and regular time intervals (daily, weekly or monthly closing prices). In addition, there are options that use a geometric averaging procedure.

FINCAD provides functions for pricing European, Bermudan and American style Asian options in all of these situations. Since it can be important to take into account of the effects of the implied volatility smile when valuing Asian options, FINCAD provides the ability to use local volatility models (normal, shifted lognormal and constant elasticity of variance (CEV) processes) and the Heston model of stochastic volatility to price European Asian options.

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To evaluate an FINCAD product that can value Asian Options, contact a FINCAD Representative

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