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A basket option is a financial derivative , more specifically an exotic option , whose underlying is a weighted sum or average of different assets that have been grouped together in a basket. For example, an index option , where a number of stocks have been grouped together in an index and the option is based on the price of the index.
Unlike a rainbow option which considers a group of assets but ultimately pays out on the level of one, a basket option is written on a basket of underlying assets but will pay out on a weighted average gain of the basket as a whole. Like rainbow options basket options are most commonly written on a basket of equity indices , though they are frequently written on a basket of individual equities as well.
For example, a call option could be written on a basket of ten healthcare stocks, where the basket was composed of ten stocks in weighted proportions.
Basket options are usually priced using an appropriate industry-standard model such as Black—Scholes for each individual basket component, and a matrix of correlation coefficients applied to the underlying stochastic drivers for the various models. While there are some closed-form solutions for simpler cases e. Problems in hedging basket options can be of some significance when dealing with markets that exhibit a strong skew.
Many operators price basket options as if the underlying basket were a single commodity following its own stochastic process with its volatility derived from its own time series. This however conflicts with a fact that an average or any linear combination of assets with lognormal distribution does not follow lognormal distribution.
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