Chapter 7: Common Contracts 323
out of the money, the option is usually hedged with vanilla
options after a while.
Put option is the right to sell the underlying stock. See the
‘Call Option’ since comments about pricing methodology,
embedded features etc. are equally applicable. Deep out-of-
the-money puts are commonly bought for protection against
large downward moves in individual stocks or against market
crashes. These out-of-the-money puts therefore tend to be
quite expensive in volatility terms, although very cheap in
monetary terms.
Quanto is any contract in which cashflows are calculated
from an underlying in one currency and then converted to
payment in another currency. They can be used to eliminate
any exposure to currency risk when speculating in a foreign
stock or index. For example, you may have a view on a UK
company but be based in Tokyo. If you buy the stock you
will be exposed to the sterling/yen exchange rate. In a quanto
the exchange rate would be fixed. The price of a quanto will
generally depend on the volatility of the underlying and the
exchange rate, and the correlation between the two.
Rainbow option is any contract with multiple underlyings. The
most difficult part of pricing such an option is usually knowing
how to deal with correlations.
Range note is a contract in which payments are conditional
upon an underlying staying within (or outside) a specified
range of values.
Ratchet is a feature that periodically locks in profit.
Repo is a repurchase agreement. It is an agreement to sell
some security to another party and buy it back at a fixed date
and for a fixed amount. The price at which the security is
bought back is greater than the selling price and the difference
implies an interest rate called the repo rate. Repos can be
used to lock in future interest rates.
Reverse repo is the borrowing of a security for a short period
at an agreed interest rate.