How Cash Settlement Works for Asian Options
Summary
The document explains how a cash-settled Asian call pays at expiration. Its payoff is based on the average of the underlying’s prices over the specified observation dates, compared with the strike. When that average exceeds the strike, the bank pays the difference in cash.
The example distinguishes this payoff from buying shares at the strike or arranging delivery of the asset. The underlying can be bought in the market only at its spot price; the historical average is used to calculate the option’s payoff, not as an executable purchase price. The response is a brief conceptual explanation, not a valuation method, and it assumes the option contract is cash settled. Settlement details can depend on the contract’s terms.
Key ideas
- An Asian option’s payoff uses the average underlying price over the contract’s observation period.
- For a cash-settled call, the issuer transfers the positive difference between that average and the strike.
- The average price used in the payoff does not let the holder buy the underlying at that price.
- The contract’s settlement terms determine how the payoff is delivered.
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Full text
# What is the mechanism of Asian option?
# What is the mechanism of Asian option?
I have no problem with the mathematical definition of an Asian option. For example, assume the strike price is $K$, the expiration date is $T$, the underlying asset has price $S(t)$, and the payoff is $$\left[\frac{1}{n}\sum_{i=1}^n S(t_i)- K\right]^+,$$ with the expiration date $T=t_n$.
Say, I bought an Asian option issued by a bank with $K=\$1$ 6 months ago and today is the expiration date. Suppose the average price in the past 6 months of the underlying asset is \$1.5. So the option is worth of \$0.5 now. My question is how the payoff is achieved, i.e. where I get this \$5 from? Does the bank give the \$0.5 directly? Or I need to do some trades on the market to get the \$0.5 as a profit.
If it's the latter case, at what price can I buy the underlying asset? Presumably it's not the strike price \$1. Because if I could buy the asset at price \$1 and if the spot price is \$2, then I could achieve \$1 profit instead of \$0.5.
## Answer by QuantK (score 5, accepted)
https://quant.stackexchange.com/a/16220
The Asian option is cash settled, so the bank will transfer you $0.5. Delivering the shares and doing some trades is not possible. You can't buy the spot for the average price over a period, you just pay the spot price.
Since you're into Asian options, I assume asian option valuation is useful for you to assess whether you're not paying too much.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.