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What are Bermuda Options
Options are financial derivatives designed to minimize risk and deliver non-linear or disproportionate return in tandem with movement in underlying assets. The options that are traded on exchanges are mainly of two different types; American and European.
As the name suggests and just like the island of Bermuda in the Atlantic ocean, Bermuda Options are sandwiched between American and European style options. These options are sometimes also referred to as mid-Atlantic options.
Let us understand all three types of options.
An American-styled option, is a version of options derivative contract that allows the holder to exercise the option any time before or on the day of expiration. It allows the investors to capitalize on gains as soon as the price of underlying moves favorably towards or away from strike price. And since the option holders have the ability to exercise the option anytime before the expiry, the American-style options are generally more expensive compared to other types of options. Because of this uniqueness, American styled options are the most popular type of options. Mostly in the US and Europe, stock options are often based on American-styled options.
An European-styled option is a derivative contract that allows for the holder of the option the right to exercise only at the expiry of the contract. Therefore, the holders are at a constraint, as they can only demand delivery or deliver underlying assets at the very end of contract. Because of the less adaptable nature of exercise conditions, the holders can miss out on capitalizing on earlier gains. The very nature of European-styled options forces the holders of options to square off the contract in order to book any gains before expiry. Being so constrained in nature, European options are often priced cheaper than the equivalent American-styled counterparts. Most index options and commodities options are European-styled.
The Bermuda-style option is essentially a derivative option contract with features that can be placed in between American and European style options. A Bermuda option can be exercised on several specified dates before the expiry of contract. Meaning the option can be exercised at a specific time during the tenure of contract and it could be anytime. For example, it could be the first Monday of every week or fourth day of the month.
The pricing of these Bermuda options is even more excotic than the island destination. Usually Monte-Carlo simulation or Binomial tree is deployed to derive theoretical value of option premium.
Advantages of Bermuda Options
- Bermuda options are generally priced lower compared to the American counterpart and a bit more expensive when compared to European options.
- The holders are permitted to exercise options on specific, predetermined dates prior to the expiry of the contract.
- Being hybrid in nature, it offers more control over trade outcomes.
- Being excotic in nature, they are mostly traded as over-the-counter bilateral contracts.
- Because of its ability to be exercised before expiration, Bermuda options are widely used for interest rate and forex derivatives by large institutions and Banks.
Since the options are priced using a very complex option pricing model, Bermuda style options are not for everybody. While they offer enormous flexibility to structure trades and payoff, these options are often deployed before occurrence of an event or in a special situation, which leads to carrying a significant event risk. In case of non-occurrence of event, the holder could lose out on opportunity to book profit in which case the traders are better off having positions in American style options.