An option that is written on a tranche– that is, one in which a tranche is used as underlying. More specifically, it is an option on a tranche spread that allows the holder to trade the volatility risk of the spread over the term of the option. A put option on a tranche (put tranche option) is the right, without the obligation, to sell risk (and buy protection) at a specific strike price, while a call option on a tranche (call tranche option) is the right, without the obligation, to buy risk (and sell protection) at a predefined strike price.
The strike price is written on the market value of the underlying credit product (such as a CDS) at the option’s expiration date. Therefore, the tranche option (tr-option) does not knock out after a portfolio undergoes a default event.
A tranche option is a type of credit portfolio derivatives.
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