Risk Latte - USD/JPY KO Installment-Premium Option

USD/JPY KO Installment-Premium Option

Third Party Contribution
Apr 18, 2005


Recently, the FX options desk of an American bank in the City executed the following trade with a corporate counterparty.

Notional Amount: USD 50,000,000

Option Type: 108.25 (ATMS) USD Put/JPY Call with KO and Installment Premium

Maturity: One year from Trade Date

Knock-Out: If, at any time from Trade Date to Maturity, the USD/JPY Spot rate trades in the inter-bank market at or above JPY 115.00 per USD, the option will automatically be cancelled, with no further rights or obligations arising for the parties thereto.

Upfront Premium: JPY x per USD (undisclosed)

Installments: JPY x per USD (undisclosed) payable monthly from Trade Date (5 equal installments)

Installment Mechanism: As long as the installments continue to be paid, the option will be kept alive, but the Counterparty has the right to cease paying the installments and to thereby let the option be cancelled at any time.

Spot Reference: JPY 108.25 per USD

Structure:

The above knock-out installment option has a put payoff but expires worthless if the barrier is ever exceeded during the life of the option.

It differs from a vanilla up-and-out put in that it is not paid for with an up-front premium but in monthly installments. The installment feature makes the option American in nature which makes valuation a bit more difficult. The holder must decide each month whether it is worth paying the next installment to keep the contract alive. This product could be used as a credit hedge.

The holder will decide on whether to pay the next installment based upon whether he is comfortable with her exposure or not. In pricing this contract one can consider all possible combinations of payment of installments and choose that which gives the option its highest value. Thus the pricing principle is exactly the same as for contracts with early exercise, the main difference being that there are now more decisions to be made; there is one decision to be made per month, instead of the single whether-to-exercise-or-not decision in an American option.


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