What is a multi-index option?
A multi-index option is a outperformance option where the gain is based on the relative performance of two indices or other assets. The payoff of these exotic derivatives is determined by the percentage change in price performance of one index or asset relative to another. They mainly trade in the over the counter (OTC).
Multi-index options are usually, but not required, European style optionswhich can only be exercised at maturity and are settled in cash.
Key points to remember
- A multi-index option is a derivative whose payoff value is based on the relative performance of one market index over another.
- These outperformance options typically measure the percentage change, or relative difference, in price over the life of the option rather than the dollar value.
- Multi-index options are considered exotic and trade only over-the-counter (OTC), settled in cash.
Understanding Multi-Index Options
Multi-index options are spread options where the gain depends on a change in relative value rather than the direction of the market. They are sometimes used by investors to hedge risk or to speculate on the relative performance of stock market indices, of different issuers in the bond markets or of exchange rates, especially when there is no cross rate commercially available. They can also be relatively inexpensive, compared to vanilla index options.
It should be noted that each index may have nominal prices. For example, with the S&P 500 trading at $3,000 and the Dow Jones Industrial Average at $30,000, 10 times higher, the nominal spread is not a good measure of relative performance. The S&P 500 may gain $10 and the Dow $20 over the term of the option; however, the percentage gain for the former would be much higher than the latter. In this case, the S&P significantly outperformed the Dow over the term of the option, although the dollar gains were larger for the Dow. Thus, the multi-index often considers the percentage change of each at the start of the contract. The spread then examines the increase or decrease in relative value between the two.
Uses of multi-index options
Multi-index options have a few main uses. The first is to allow speculators to bet on the performance of two indices relative to each other. Speculators can choose two indices within a country, two county indices, two sectors, etc.
Blankets also find useful multi-index options to reduce risk in markets or asset classes. For example, stocks in different countries may be affected by the political landscape, interest rates and/or currencies of their own country. If the holder believes that both markets have similar prospects, but one has additional risks due to its home market, the option can help mitigate that risk.
Example of a multi-index option
For example, consider a multi-index option on the relative performance of the S&P 500 versus the TSX Composite Index of Canada over one year. If the option has a exercise price of 5% – the threshold between the option paying off or expiring worthless – then, if the S&P500 fell 2% but the TSX fell 9% after one year, the option will have a positive gain of 2% because the S&P 500 has outperformed the TSX by 7% points. If the S&P 500 outperforms by less than 5%, the option will expire worthless.
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