Bermudan Option: Definition, Example, Pricing

An option is a contract that provides its holder with the right to buy or sell an underlying asset or security. It involves a specific price before or on a predetermined date. However, it does not obligate them to do so. There are several option styles, which represent the class into which an option falls.

Usually, the dates on which holders can exercise the option define its style. The most prevalent of these include American and European options. However, investors can also acquire less common exercise rights. One of these is the Bermudan option, which combines the characteristics of both of the above.

What is a Bermudan Option?

A Bermudan option is an option that gives the holder the right to exercise a set number of times. These options fall between European and American options. Usually, European options only allow the holder to exercise at the expiration date. On the other hand, American options provide the right to exercise at any time. Bermudan options do not have the right to exercise at expiration or any time. Instead, they allow holders to exercise several set dates.

A Bermudan option differs from the traditional options and, therefore, falls under exotic options. It comes with predetermined dates, which are when the holder can exercise the option. Usually, these dates come after regular intervals, for example, on a specific day each month. Apart from this, Bermudan options have the same features as other options.

Bermudan options allow investors to buy or sell an underlying asset or security at a preset price. However, it does not specify a single date or allow exercise at any time. Instead, it sets several dates along the expiration date to exercise. These exercise dates fall close to the option’s expiration date. Due to these features, Bermudan options fall between American and European options.

Example

An investor purchases a company’s stocks for $100. However, they are unsure whether the stock’s price will decrease in the future. Therefore, they acquire a Bermudan put option with an expiry of a year. This option protects the investor from a decrease in the stock’s price below $95 for the year. Similarly, it contains a feature to exercise on the fifth of each month after the 8th month.

The Bermudan option provides the investor with various benefits. Firstly, it allows them to stay protected against any price falling beneath $95. Similarly, it provides them with the opportunity to sell the stock at the exercise price on the fifth of each month. Regardless of how much the stock’s worth will be at the time, investors can use the option to gain benefits.

What is the pricing of Bermudan Options?

The pricing of Bermudan options introduces various challenges. These challenges stem from the several set of dates that these options define. In this regard, Bermudan options are similar to American options. Unlike European options, both of these options pose challenges when it comes to pricing. However, several techniques can help determine the value of Bermudan options.

Bermudan options can be valued by using the Binomial Tree approach.  Analysts can also use a Monte-Carlo framework to value Bermudan options. However, it will not take the traditional approach to evaluate options that require the value of the options. Instead, it involves an optimal exercise strategy. There are several approaches that analysts can take when using Monte Carlo simulations for evaluating Bermudan options.

One approach to pricing Bermudan options is the dynamic programming approach. With this approach, the option value for each set date becomes the maximum of the payoff associated with immediate exercise. This value is known as the intrinsic value. It also involves determining the continuation value, although this process is more challenging.

Conclusion

An option provides the holder with the right to buy or sell an underlying asset or security at a specific price at or during a predetermined time. Bermudan options allow the holder to exercise on a set of specified dates, usually at regular intervals. The pricing of Bermudan options is a challenging process. There are several methods that analysts may use for this process.

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