Author(s)

Xuan Peng, Zhehan Hu, Zhaolin Liu

Corresponding Author

Xuan Peng

ABSTRACT

A rainbow option is an option that allows the holder to decide whether it is a call or put before the expiration date or to choose the best of two alternative options which we focuses on in this article. The rainbow option to choose the best call option on underlying assets between NASDAQ and S&P 500 is under research in our study. First, to obtain the transmission that how the characteristics of NASDAQ and S&P 500 influence the option price, Monte Carlo Simulation method has been utilized to simulate the price path along with inputs including correlation between two underlying assets, risk-free-rate, historical return and market volatility. Based on that, sensitivity of option value has been conducted to figure out the relationship between the option value with all specific inputs. The result indicates that risk-free rate and volatility have a positive correlation with call value, and striking price has a negative one. In addition, we use the loglog plot and conclude that the volatility as opposed to risk-free-rate and striking price contributes the most to the fluctuations of option value. Finally, we extended our conclusion into the reality to predict the rainbow option price and analyze that to which extent the rainbow option would hedge risk compared with other common options. Given the situation that the financial market has been substantially influenced by Covid-19 and accompanied with a broad quantitative easing monetary policy, risk-free-rate is globally lower than before and financial market volatility climbs up higher. It’s reasonable to make a prediction that the risk-free-rate will stay low and strike price will remain stable for a long time, while the market volatility will decrease sharply by 30% to 60% due to the close-to-zero policy interest rate. Therefore, we conclude that the corresponding rainbow option price will drop significantly. In this case, rainbow option performs better for greatly hedging the volatility.

KEYWORDS

Rainbow Options, Monte Carlo Simulation, Sensitivity Analysis, NASDAQ, S&P 500