An average rate option which gives the holder the right, but not the obligation, to buy the underlying asset, with the option’s payoff being the arithmetic or geometric average of the underlying price over a specific period of time, not just the spot price at expiration date. Average rate call options are almost always less expensive than equivalent ordinary call options for two reasons: (1) the volatility of the average price of the underlying asset is lower than the volatility of its absolute price. (2) the forward value of the average price typically less than the normal forward price. For example, the price of a two-year at-the-money call on the level of a given price index could be 10%, whilst that of a comparable call on the “average” index level might cost 8% (it gives the holder the right to exercise on the index level at the end of year 1 and year 2).
Derivatives
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