Rainbow Option

Rainbow option is referred to as an option, which diminishes risks involved in putting options on multiple assets, which are correlated. Rainbow option, the standard form may be of several types. The article below furnishes details of the same.
Rainbow option may be referred to an option, which is connected to more than two or two underlying assets. However, it is obligatory that if the option has to payoff, the underlying assets (all of them) be required to move in similar directions.

The underlying assets may differ from one another in various aspects like:

  • Strike price
  • Features
  • Expiry dates

Understanding Rainbow Option:
An example will help in making the concept of rainbow option clear. For instance, a soccer match is to be held at a venue, there are four soccer fields at close proximity. In one field, a soccer match is about to end, in another field the soccer match is going on, in the third field the soccer match is scheduled to start within an hour or two and in the last field soccer match just started.
If an investor bets on the winners of all the three matches, he is benefited but if any one of the matches is lost, the investor gets nothing at all.

There are several standard forms of rainbow options.

They may be summed up as below:

Spread option
Worst-of option
Two asset correlation option
Maximum option
Minimum option
Better-of option

It may be mentioned here that maximum option as well as minimum option together are referred to as min-max options. The better of option as well as worst-of option together is referred as alternative options. Spread option as well as out performance option may be referred as a rainbow option class of one type.
Features Of Rainbow Option:
In the event when two assets are extremely correlated, options on the assets are not so expensive. On the contrary, if the assets are not so much correlated, options on them become comparatively expensive. As a rule, if assets have less correlation, there is more variability.
Advantage Of Rainbow Option:
Rainbow options may be used as instruments for hedging uncertainties pertaining to multiple assets.