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Bermuda Options

Bermuda Options

What is Bermuda Options?

Bermuda Option refers to those options which can be exercised on fixed dates (which are predetermined in advance) after the completion of the lock-in period. In other words, it gives the holder of the option the right to exercise on a specific set of dates during the life of the option.

Bermuda Option is a blend of the two other popular exotic options namely American option and European option and it got its name from the place Bermuda which lies between these two places. It is also called the Mid-Atlantic Option. Thus exercise date for such Option is restricted to certain dates unlike American options which can be exercised anytime or European Option which can be exercised only on maturity of the option. Due to these inherent features, these options are usually priced more compared to European Option and Less compared to American option.

Examples of Bermuda Option

ABC limited purchased shares of Reliance Industries Limited @ $1000 per share on 01.01.2019. The company bought 20000 shares amounting to 20 million dollars. To protect itself from any downside ABC Limited decided to purchase Bermuda Option with an Exercise Price of $980 with a six-month expiry ending on 30.06.2019 and option to exercise on the first date of every month for $10 per share option.

Details are as follows:

Bermuda Option Example

The option allows ABC Limited multiple benefits namely:

  • It provides downside protection against any price erosion below 980$.
  • Provides the opportunity to sell the stock at the exercise price on the first day of every month irrespective of the price of the Stock on that date (Mostly option is exercised only when it is in the money i.e. Price is less than the strike price of $980).

Thus if the price falls below $980, ABC Limited can sell the stock on the pre-specified dates and protect itself from the further downside.

Comparison between Bermuda Option vs American Option

Particulars Bermuda Option American Option
Definition Bermuda Options are those option which can be exercised on specified dates as well as on Expiry period. American Options can be exercised anytime on or before the Expiry period.
Customized/Standard They are customized and bilaterally traded. American Options are standardized and traded on recognized exchange platforms.
Premium Cost Always less compared to American Options Always more than Bermuda Option.
Exercise Freedom It can be exercised on expiry or certain specified dates. It can be exercised anytime on or before expiry.

Advantages

  • They are less expensive compared to American Options and offer better exercising options than European options.
  • These options are over the counter traded (OTC) products and offer customized trades compared to standard options which are standard.
  • This type of option is mostly used in Interest rate Contracts and Forex Markets.
  • These options are a good choice for companies that have to receive payments in foreign currency and have the option to receive it on some prefixed dates. In such cases, the company can be better off by buying a Bermuda Option and paying less premium compared to an American Option.

Disadvantages

  • It cannot be exercised at any time like American options and exercisable only on specified dates which are predetermined.
  • These options are expensive compared to European Options and buyer is better off opting for European Option if the intention is to exercise only on expiry of the option.
  • It can be exercised only on specific dates which may not be the best days to exercise the option.
  • It offers writers of such options to exercise more control over when the option can be exercised rather than on the option buyer.
  • It requires the use of complex option pricing models and can’t be undertaken using the standard Black Scholes Option pricing model.

Important Points to Remember

Bermuda Options acts as a mixture of American and European Options; however, what makes them more relevant and useful is that they provide specified dates on which they can be exercised before expiry and are less costly compared to American Options which allow exercising any time on or before expiry. Thus if a trader expects movement in the underlying asset over a specified period/dates only due to any external event or event associated with the underlying asset he/she can generate a better cost-effective return by opting for a Bermuda Option than American Option.

For instance, Traders betting on prices of Crude Oil can opt for Bermuda Option when OPEC (Oil producing and Exporting countries) meet ( which directly impacts the prices of Crude Oil) coincides with the specific dates as that can safeguard the cost rather than opting for American Option, thereby gaining from the hybrid model.

Conclusion

Bermuda Option is mostly Over the Counter Traded options and is used often as a hedging instrument for interest rate contracts and foreign exchange contracts. It offers more flexibility compared to European options. Such options are also used for specific situations or event-specific purposes. The writer of such options makes use of extensive quantitative techniques and sophisticated option Pricing Models to price these complex derivative instruments. These exotic options offer more flexibility compared to a European Option at the expense of additional premium and less exercising opportunities compared to American Option by being less expensive compared to American Options.

Recommended Articles

This has been a guide to Bermuda options and its definition. Here we discuss an example and its comparison with the American option along with advantages and disadvantages. You can learn more about financing from the following articles –

  • How to Trade Options?
  • Index Options Meaning
  • What are Non-Qualified Stock Options?
  • Comapre – European vs American Option

The post Bermuda Options appeared first on Wallstreet Mojo.



This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here

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