Analysis of pricing methods for basket options

Abstract

A Basket option is an option whose payoff depends on the value of a portfolio of assets. The composition of the portfolio including the weights of each asset is defined at the time of writing the contract. Basket options are attractive because of their cost; an option on a basket is cheaper than buying options on the individual components as price of the option varies directly with correlation. The payoff profile of basket options is also attractive as a basket option more closely replicates the changes in a portfolio's value than any combination of options on the underlying assets. Such options are extremely popular as index options where the underlying asset is a weighted index calculated on prices of various assets such as stocks, commodities, fixed income instruments, currencies, etc. Basket options are growing in popularity as a means of hedging the risk of a portfolio. Other advantages of Basket options include administrative ease of "book keeping" and exercising. These options also provide the flexibility of including any number of assets in the investor's portfolio without any constraints on size.