Refund Barrier Option Definition


What is a refund barrier option?

A redemption barrier option is a barrier option that includes a redemption provision. These types of options offer investors a payback based on a specific underlying asset price, known as a barrier price. Discounts associated with barrier options are provided to investors when a barrier option cannot be exercised.

Key takeaways

  • A redemption barrier option is a type of exotic option that includes a redemption provision paid to investors if the barrier option cannot be exercised.
  • Redemption provisions can be included in variations of knock-in (down and in; up and in) or knock-out (down and out; up and out) options.
  • Refunds typically take the form of a percentage of the premium paid by the holder for the option.

Understanding Refund Barrier Options

Redemption barrier options are an example of standard barrier options that include a redemption provision for investors when the option cannot be exercised. Barrier options can be offered in two generalities and four different forms, which are explained below. All forms of barrier options may contain a provision to provide refunds or payments to holders if the option does not reach the barrier price and becomes worthless when it expires.

These options are known as repayment barrier options. Refunds, in such cases, take the form of a percentage of the premium paid by the holder for the option to the other counterparty.

Redemption barrier options can be complex and fall under the category of exotic options. Exotic options are known to have complex structures that are based on the basic concepts of simple options but include non-standard terms.

Redemption Barrier Option Variations

Like all options, barrier options give the holder the right, but not the obligation, to buy or sell a financial asset at an agreed price based on his option position. Barrier option contracts are generally US options that allow the holder to exercise at any time until expiration. Where barrier options differ from standard options is in their barrier price, which can make the option effective or defective.

Generally, there are two broad types of barrier options: knock-in or knock-out. Insertion options can be down and in or up and in. Elimination options can be down and out or up and out. Each of these different types of options can include a redemption provision.

Knock-In option

Knock-in options become effective when a specific barrier price is reached or exceeded, depending on the terms. When the barrier price is reached, the holder has the right to exercise until maturity. These options could offer a refund to the holder if the option is never activated.

  • Down and in: A downward and inward barrier option will take effect when a price reaches or falls below a barrier price.
  • Up and in: An ascending barrier option will be effective when a price reaches or moves above a barrier price.

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Knock-Out option

Knock-out options are the opposite of knock-in and become flawed when a barrier price is reached. When the barrier price is reached, the option can no longer be exercised. These barrier options can offer a refund to the holder if the option proves defective.

  • Down and out: In a drop and exit option, the option becomes defective when the price reaches or falls below the barrier.
  • Up and out: In a rise and fall option, the option becomes defective when a price reaches or moves above the barrier.
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