An Asian option (a) is a cash-settled option whose payout is determined by the average value of the underlying asset on a predetermined set of dates (known as fixings) over the life of the option rather than by the actual value of the underlying asset at expiration (as is used for a vanilla).
The average of the underlying is calculated by taking the underlying on a specific series of dates (or fixings). When determining the fixings, you can also edit the weighting assigned to each date. By default, all dates chosen carry the same weight, that is, 1.
If the average rate is better than the strike, the option is in the money and it is cash settled. That is, the settlement is made in cash as opposed to physical delivery of the underlying asset.
The underlying asset for an Asian option is a swap; for an Asian strip it is a swap strip.
Why enter into an Asian option?
There are a number of reasons why you would want to enter into an Asian option, as follows:
Asian options are extremely important in the commodities markets, offering advantages to both the consumer (buyer) and the producer. For example, many consumers are interested in hedging average costs as their supply contracts are based on average purchase prices. The producers are often interested in meeting budget targets that are based on average prices over the planning period. For both parties, Asian options fit their risk profiles and allow them to achieve their goals at reduced costs, because these contracts are typically less expensive than the corresponding European options.
Asian options are generally less expensive than the corresponding European options. Why? Because the Asian option is based on an average price, the 'implied volatility' of an average price is less than the volatility of the underlying prices used in the calculation of the average. Because of this relationship, an Asian option at inception is much like a European option with lower volatility. This makes the Asian option less expensive than its corresponding European option, since a vanilla option's premium increases with increasing volatility.
In addition to the lower cost, another advantage of an Asian option is that its payoff is less sensitive to extreme market conditions that may prevail on the expiration day (due to random shocks or outright manipulation).
From the point of view of the option writer, Asian options are preferred products because they are easier to hedge. Asian options with long averaging periods do not have the high gamma risk that characterizes European options near expiry. After the Asian option enters its averaging period and the average begins to set, the gamma risk of the option decreases and approaches zero near the end of averaging for options with reasonably long averaging periods.
Pricing an Asian option in SDX Commodities & Energy
You can enter into a composite or quanto version of an Asian (a).