Refund Options on South African Equities
12 Pages Posted: 11 Apr 2013 Last revised: 16 Apr 2013
Date Written: November 11, 2002
A cost-effective structure is sought whereby an institution can hedge its balance sheet against adverse market movements. Vanilla puts would suffice but it is generally very expensive if these puts are rolled on a continuous basis. An institution, however, might be willing to pay the intrinsic value of the put back to the writer thereof if the market corrects after the put has expired. Paying the intrinsic value back after a certain time frame reduces the cost of the option.
This holds for any portfolio manager who is managing a fund and who wants to protect the fund from a fall in the market. If the put is in the money at its expiry, it will be exercised and the investor’s exposure is hedged. If the market corrects afterwards, it can be debated that the hedge was not necessary in the first place and the profit from the hedge can be paid back to the writer of the hedge. Because of this last feature we will name these type of options refund options.
The purpose of this paper is to develop, define and value a refund structure with the above mentioned properties.
Keywords: Option pricing, Hedging, Exotic Options, Balance sheet, Black and Scholes, Intrinsic value, cheaper options
JEL Classification: G12, G13
Suggested Citation: Suggested Citation