Many risk management situations require an option that has as its underlying asset not a single commodity, but a group of individual commodities. For example, an oil refinery which produces unleaded gasoline and heating oil. Though these two refined products are very active and very liquid and the refinery can hedge these risk exposures separately, it may be better for this refinery to adopt a portfolio approach.
A basket option (b) gives you the right to buy or sell such a group of commodities, as long as they all trade in the same currency. This group of commodities is called a basket, and one unit of the basket is made up of weighted amounts of the components (each asset is weighted according to the user’s exposure to it). This lets you price a basket of underlying assets where the basket combines long and short positions against the base currency. This can include:
Positive weights (these represent long positions against the base currency)
Negative weights (these represent short positions against the base currency)
The basket is then considered the underlying asset, and has its own forward price and volatility. The forward price and strike are defined as how much will one unit of the basket cost in the base currency. Each component in the basket contributes to determining the baskets’ forward price, and the ultimate payoff of the option. On the specified date, the basket’s holder can exchange a specified amount of base currency for specific quantities of two or more commodities.
At expiry, the payout is in the same currency as the currency in which all the components are traded.
Baskets are the most commonly traded of all correlation trades, and they are usually cash settled.
Pricing a basket in SDX Commodities & Energy
Currently a basket (b) can only be priced in the Single Option page.