Introduction
This article seeks to shed light on one of the more exotic options available in the financial markets today i.e., the Bermuda option. Its name is derived from the British island territory.
Looking at What a Bermuda Option Is
Recognized as one of the more exotic options contracts in the market today, a Bermuda option allows holders to only exercise it on predetermined dates that often fall on a single day every month.
A Bermuda option operates in a style akin to that of American-style options. These options allow holders to exercise their contracts early on at a time of their choosing. In the same vein, Bermuda options permit investors to buy or sell their securities or underlying assets at predetermined prices on an outlined set of certain dates in addition to the expiration dates of the options.
Understanding How Bermuda Options Operate
Options contracts refer to financial derivatives that give a buyer the right, but not the responsibility, to transact an underlying asset. This may be in the form of shares of stock. This transaction occurs at a certain price called the strike price and takes place on or prior to a certain future date that has been made clear.
A call option refers to an option that allows one to buy an underlying asset. On the flip side, a put option refers to an option that allows one to sell an underlying asset. The expiration date of the option is a time when the contracts can be transferred into shares of the asset at a preset price. Those that partake in such activities are said to exercise their contracts.
There exist two leading forms of options i.e., American and European options. The former refers to those options that can be exercised at any point in time ranging from the date of purchase to that of expiration. On the flip side, European options may only be exercised at the date of expiration. Set against this backdrop, Bermuda operations operate in the style of the American option alone that permits an early exercise that may only be done on outlined dates.
With this early exercise offering, investors who hold Bermuda options can use their option and convert it to shares on certain dates prior to its expiration. These dates are listed under the contract’s terms and are known to all parties involved at the time of the option being purchased.
Things to Keep in Mind
The first business day of a month maybe a permissible date for investors to exercise their option under certain Bermuda options. If so, this means that if on the first business day of the month, should an investor’s Bermuda call option’s strike price fall below that of the underlying stock’s market price, then the investor may choose to exercise their option and can purchase shares for the smaller strike price. On the flip side, should the investor’s strike price for their put option fall to a value above that of the stock’s market price, the investor is entitled to choose to sell their holdings at the strike price. They can collect the shares at the smaller market price. In most instances the net difference is cash-settled.
That being said, a handful of Bermuda options come with early expiration date limitations tethered to them.
A contract’s value may rise if it allows for an option to be exercised early as it gives an advantage to the holder. The premium listed under a Bermuda option is often higher than that of a European option which has the same terms listed under it. That being said the premium placed on a Bermuda option falls below that of an American option owing to the limitations that lie under early exercise.
Bermuda options are customized and bilaterally traded whereas American options are standardized, and their trade occurs on recognized exchange platforms.
Examining the Advantages and Disadvantages of Bermuda Options
Bermuda options bring with them a broad range of benefits and shortfalls. In sharp contrast to American and European options, Bermuda options allow investors to generate and purchase hybrid contracts. This means that they are given greater control over when they exercise their options.
When looking at their advantages, the following facts become apparent.
– Bermuda options involve premiums that fall below their American counterparts.
– Investors are permitted to exercise their option on certain dates prior to the date of expiration.
– This option is often used under interest rate contracts as well as within forex markets.
– Recognized as, over counter trade products, Bermuda options allow for customized trades as opposed to standard options.
– Companies that seek to be paid in foreign currencies can take advantage of Bermuda options and can organize to receive their payments on certain prefixed dates. In such scenarios said companies would benefit from the comparatively lower premiums charged.
When looking at their disadvantages, the following facts become apparent.
– Bermuda options involve premiums that are significantly higher than their European counterparts.
– Just because holders of Bermuda options are permitted to exercise their options at an early stage, there is no guarantee that said time is the most lucrative time to exercise the same.
– Those that use Bermuda options must make use of complex option pricing models that aren’t easy to navigate.
– Writers of such options have greater control over when the option is exercised as opposed to who the option buyer will be.
Conclusion
Ordinarily functioning as over the counter traded options, Bermuda options are often used to hedge interest rate contracts in addition to foreign exchange contracts. These options are ordinarily employed for specific situations. They involve writers making use of elaborative quantitative techniques and pricing models such that they can discern what the price of these complex derivative instruments ought to be. Finally, Bermuda trading is bilateral.
