CHAPTER 9.

MULTIFACTOR OPTIONS 103

Chapter 9

Multifactor options

A multifactor option is one of the second-generation options 1 . In contrast to

standard options, the value of a multifactor option is determined by the behaviour
of two or more financial prices and by the correlation between these financial
prices. The multifactor options can be subdivided into three groups: rainbow,
quanto and basket options.

9.1 Rainbow options

The value of a rainbow option is determined by the performance of two or more

underlying assets. Such an option based on n underlying assets is referred to as
an n-colour rainbow option, for example, one based on two underlying assets is
referred to as a ”two-colour rainbow”. We are aware of three different payout
structures for rainbow options.

9.1.1 Better-of/worse-of options

Better-f options have been used widely in the equity markets, allowing investors
to obtain the return associated with the better-performing of some number of
1
First part of this chapter is from C. Smithson, ”Multifactor options” RISK, vol.10,p.43,
1997
CHAPTER 9. MULTIFACTOR OPTIONS 104

equity indexes. for example, an investor could buy a better-of option that would
pay according to the better performing of the DAX(Stock index in Germany) or
FTSE had increased by 13% and the Dax had decreased by 6%, the holder of the
rainbow option would receive a return based on the 13% increase in the FTSE.
If both indexes had declined, the holder would pay the performance of the asset
with the smaller decrease in value.
While better-of options usually involve assets from the same asset class, they
can involve assets from different asset classes. A popular combination in the early
1990s was a better-of option based on the performance of a stock market index
and a bond market index.
The payout of n-colour better-of rainbow option is:

max(S1 , S2 , S3 , · · ·, Sn )

and the payout of n-colour worse-of rainbow option is:

min(S1 , S2 , S3 , · · ·, Sn )

where Si is either the price level or the percentage change in asset i.

9.1.2 Outperformance option

An outperformance option2 is based on the difference in the performance of two

assets. For example, an investor holding a position in the Dax could protect
against the Dax underperforming the FTSE by purchasing a rainbow outperfor-
mance option that would pay out according to the difference in returns of the
two indexes-but only if the FTSE outperformed the Dax. If the FTSE increased
by 13% and the Dax decreased by 6%, the holder would receive a return based
on the 19% spread between the returns. But if the FTSE underperformed the
Dax, the payout is zero.
2
Outperformance options are sometimes referred to as ”spread” options but there is a dif-
ference. In contrast to the payout for the outperformance option where the strike is generally
zero, the payout structure of spread option is max(S2 − S1 − X, 0).
CHAPTER 9. MULTIFACTOR OPTIONS 105

The payout of an outperformance option is

max(S2 − S1 , 0)

where Si is either the price level or the percentage change.

9.1.3 Max/min option

A max/min option depends on the maximum or minimum of two or more assets,

for example, shares. The payout of a max call option is:

max(max(S1 − X1 , S2 − X2 , · · ·, Sn − Xn ), 0)

and the min call option is

max(min(S1 − X1 , S2 − X2 , · · ·, Sn − Xn ), 0).

The max/min option payout is similar to that of better-of/worse-of options

when the strikes X1 through Xn are set to zero.

9.2 Quanto options

Quanto options eliminate the exchange rate risk inherent when buying an asset
denominated in a currency other than the purchaser’s home currency.
Suppose a US investor buys a European option giving him the right to buy a
£-denominated asset (for example, FTSE). At maturity, the dollar value of this
option depends on the spot $/£ exchange rate at option maturity(F XT ) and the
value of the £-denominated asset(S£ ):

Value at T = F XT × max(S£ − S, 0)

Alternatively, the US investor might want an option which eliminates the foreign
exchange rate risk. This is done by fixing the exchange rate on the date when
the option is purchased (F X0 ). At maturity, the dollar value of such an option
would be
Value at T = F X0 × max(S£ − S, 0)
CHAPTER 9. MULTIFACTOR OPTIONS 106

With the quanto, the investor does not gain (lose) from an appreciation (depre-
ciation) of £. However the writer of the option is confronted with a new exposure
not present in the standard £-denominated call: the option seller has taken on
exposure to £ on an uncertain amount-max(0, S£ − X). To hedge this risk, the
option writer must consider the correlation between the value of the underlying
asset and the foreign exchange rate.
There is an alternative form of quanto options called a joint quanto. In this
case, the value of the option depends on the spot $/£ exchange rate at option
maturity relative to a guaranteed level of the exchange rate (F Xguaranteed ). At
maturity, the dollar value of such an option would be

max(F XT , F Xguaranteed ) × max(0, S£ − X)

9.3 Basket options

A basket option pays out on the basis of the aggregate value of a specified basket
of financial assets, rather than on the value of the individual assets. It is an
application of portfolio theory- as long as the financial prices that comprise the
basket are less than perfectly positively correlated, the option on the basket
will be less expensive than buying individual options on each of the assets. At
maturity, the value of basket call option is
X
max( αi Si − Xbasket )
i

where αi is the percentage of asset i in the basket, Si is the price of asset i and
Xbasket is the strike price defined in terms of the aggregate value of the basket.
Basket options are often used for foreign exchange. For example, a US firm
that exports goods to Britain and Japan might want protection against the dollar
rising relative to the Sterling and the Japanese yen. It could buy separate put
options on both the Sterling and the yen or it could buy a basket option on the
CHAPTER 9. MULTIFACTOR OPTIONS 107

pair of currencies. Because the Sterling and yen are not perfectly correlated, the
basket option will be cheaper than the corresponding basket of two options. this
is essentially the same as creating an index on which to base the option and has
the same effect of lowering the volatility.