What is Bermuda Options?
Bermuda Option refers to those options which can be exercised on fixed dates (which are predetermined in advance) after the completion of the lock-in period. In other words, it gives the holder of the option the right to exercise on a specific set of dates during the life of the option.
Bermuda Option is a blend of the two other popular exotic optionsExotic OptionsExotic options, as the name suggests, are more complex variations of the simple vanilla options, in terms of trigger points, payoff determination, expiry, underlying assets and other such features. They are designed to suit to the needs of the partaking investors and therefore sell through the Over-the-Counter (OTC) market.read more, namely the American option and European optionEuropean OptionA European option can be defined as a type of options contract (call or put option) that restricts its execution until the expiration date. In layman's terms, once an investor has purchased a European option, even if the underlying security's price moves in a favourable direction, the investor cannot take advantage by exercising the option early.read more, and it got its name from the place Bermuda, which lies between these two places. It is also called the Mid-Atlantic Option. Thus exercise date for such option is restricted to certain dates, unlike American options, which can be exercised anytime, or European Option, which can be exercised only on the maturity of the option. Due to these inherent features, these options are usually priced more compared to European Option and Less compared to the American option.
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Source: Bermuda Options (wallstreetmojo.com)
Examples of Bermuda Option
ABC limited purchased shares of Reliance Industries Limited @ $1000 per share on 01.01.2019. The company bought 20000 shares, amounting to 20 million dollars. To protect itself from any downside, ABC Limited decided to purchase Bermuda Option with an Exercise Price of $980 with a six-month expiry ending on 30.06.2019 and the option to exercise on the first date of every month for $10 per share option.
Details are as follows:
The option allows ABC Limited multiple benefits, namely:
- It provides downside protection against any price erosion below 980$.
- Provides the opportunity to sell the stock at the exercise price on the first day of every month irrespective of the price of the stock on that date (Mostly option is exercised only when it is in the moneyIn The MoneyThe term "in the money" refers to an option that, if exercised, will result in a profit. It varies depending on whether the option is a call or a put. A call option is "in the money" when the strike price of the underlying asset is less than the market price. A put option is "in the money" when the strike price of the underlying asset is more than the market price.read more, i.e., the price is less than the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more of $980).
Thus if the price falls below $980, ABC Limited can sell the stock on the pre-specified dates and protect itself from the further downside.
Comparison between Bermuda Option vs. American Option
| Particulars | Bermuda Option | American Option |
|---|---|---|
| Definition | Bermuda Options are those option which can be exercised on specified dates as well as on Expiry period. | American Options can be exercised anytime on or before the Expiry period. |
| Customized/Standard | They are customized and bilaterally traded. | American Options are standardized and traded on recognized exchange platforms. |
| Premium Cost | They are always less compared to American Options. | Always more than Bermuda Option. |
| Exercise Freedom | It can be exercised on expiry or certain specified dates. | It can be exercised anytime on or before expiry. |
Advantages
- They are less expensive compared to American Options and offer better exercising options than European options.
- These options are over the counterOver The CounterOver the counter (OTC) is the process of stock trading for the companies that don't hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments.read more traded (OTC) products and offer customized trades compared to standard options which are standard.
- This type of option is mostly used in Interest rate Contracts and Forex Markets.
- These options are a good choice for companies that have to receive payments in foreign currency and have the option to receive it on some prefixed dates. In such cases, the company can be better off by buying a Bermuda Option and paying less premium compared to an American Option.
Disadvantages
- It cannot be exercised at any time like American options and exercisable only on specified dates, which are predetermined.
- These options are expensive compared to European Options, and the buyer is better off opting for European Option if the intention is to exercise only on the expiry of the option.
- It can be exercised only on specific dates, which may not be the best days to exercise the option.
- It offers writers of such options to exercise more control over when the option can be exercised rather than on the option buyer.
- It requires the use of complex option pricing models and can’t be undertaken using the standard Black Scholes Option pricing model.
Important Points to Remember
Bermuda Options acts as a mixture of American and European Options; however, what makes them more relevant and useful is that they provide specified dates on which they can be exercised before expiry and are less costly compared to American Options, which allow exercising any time on or before expiry. Thus if a trader expects movement in the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more over a specified period/dates only due to any external event or event associated with the underlying asset, he/she can generate a better cost-effective return by opting for a Bermuda Option than an American option.
For instance, Traders betting on prices of Crude Oil can opt for Bermuda Option when OPEC (Oil producing and Exporting countries) meet ( which directly impacts the prices of Crude Oil) coincides with the specific dates as that can safeguard the cost rather than opting for an American option, thereby gaining from the hybrid model.
Conclusion
Bermuda Option is mostly Over the Counter Traded options and is often used as a hedging instrument for interest rate contracts and foreign exchange contracts. It offers more flexibility compared to European options. Such options are also used for specific situations or event-specific purposes. The writer of such options makes use of extensive quantitative techniques and sophisticated option Pricing Models to price these complex derivative instruments. These exotic options offer more flexibility compared to a European Option at the expense of additional premium and less exercising opportunities compared to the American option by being less expensive compared to American Options.
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This has been a guide to Bermuda’s options and its definition. Here we discuss an example and its comparison with the American option along with advantages and disadvantages. You can learn more about financing from the following articles –
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