Chapter 7: Common Contracts 311
exposed to prices over a long period of time, and hence their
exposure is to the average price.
Asset swap is the exchange of one asset for interest payments
for a specified period.
Balloon option is an option where the quantity of option
bought will increase if certain conditions are met, such as
barriers being triggered.
Barrier option has a payoff that depends on whether or not a
specified level of the underlying is reached before expiration.
In an ‘out’ option if the level is reached (triggered) then
the option immediately becomes worthless. In an ‘in’ option
the contract is worthlessunlessthe level is triggered before
expiration. An ‘up’ option is one where the trigger level is
above the initial price of the underlying and a ‘down’ option
is one where the trigger level is below the initial price of the
underlying. Thus one talks about contracts such as the ‘up-
and-in call’ which will have the same payoff as a call option
but only if the barrier is hit from below. In these contracts
one must specify the barrier level, whether it is in or out,
and the payoff at expiration. A double barrier option has both
an upper and a lower barrier. These contracts are bought
by those with very specific views on the direction of the
underlying, and its probability of triggering the barrier. These
contracts are weakly path dependent. There are formulæ
for many types of barrier option, assuming that volatility is
constant. For more complicated barrier contracts or when
volatility is not constant these contracts must be valued using
numerical methods. Both Monte Carlo and finite differences
can be used but the latter is often preferable.
Basis swap is an exchange of floating interest payments of
one tenor for floating interest payments of another tenor,
a six-month rate for a two-year rate for example. Since the
two payments will generally move together if the yield curve
experiences parallel shifts the basis swap gives exposure to
non-parallel movements in the yield curve such as flatten-
ing or steepening. More generally basis swap refers to any
exchange in which the two floating rates are closely related,
and therefore highly correlated.