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In this section we continue our look at barrier options by briefly considering barrier option variations. To get the most from this section you should first have covered the sections on reverse knockout options, reverse knockin options, binary options and double knockout options, knockout options and knockout option risk management considerations.
Most barrier options that are traded in the market are so called “American Style Barriers”. This refers to the fact that the barrier can be triggered at any time that the market is open. So, if spot trades at or beyond the barrier at any time between the open of the market in Sydney on a Monday morning until the close of the market in New York on a Friday afternoon then an American Style Barrier would be triggered. In practice, exotic option market makers give an order to their spot desks to trade at the barrier. If the order gets filled then the barrier is triggered.
In contrast to American style barriers that are continuously monitored, European Style Barrier can only be knocked out at discrete observation times. Typically a European Style Barrier can only be knocked out at a daily observation time. This observation time is usually linked to a central bank fixing or other publicly available rate.
A variation on the American Style Barrier is the Window Barrier. A Window Barrier can only be knocked during a fractional period of the life of the option, for example, a six-month option that can only be knocked out during the last three months. In this case the barrier window is the last three months. The window can be set to be any period within the life of the option. However, it is usual to only have one window where the barrier can be triggered.
As there is less chance for the barrier to be triggered window barrier options are more expensive than the equivalent non-windowed American style barrier. However, the difference in price can be small. For this reason windowed barriers can appear much more attractive to clients, particularly if they have a specific view of how they expect the market to trade. The most attractive windows on regular knockouts are for windows that are set at the initial period of the option. For reverse knockout type options the price looks most attractive to clients if the window is placed for the final period of the option.
For other barrier types, the whole face amount of the option either knocks in or knocks out on a barrier being triggered. For a fading barrier a daily observation is taken (as for a European style barrier) and if spot is beyond the barrier then a fraction of the option either knocks in or knocks out.
For a one year option for which there are, say, 250 daily observations then typically 1/250th of the face amount would knock out for a fade-out option or knock in for a fade-in option.
Dual Asset Barriers have a barrier that is dependent on a different underlying to the option. For example, you might have a EUR put / USD call option with a barrier that is dependent on USD/JPY spot.
The barrier and underlying options need not be both FX based. You might have a interest rate option such as a Swaption that is either knocked in or out depending on a barrier being triggered in EUR/USD spot.
In the next section we continue our introduction to barrier options by looking at barrier option intuition.