Knock-in/Knock-out (KIKO) options are a type of exotic derivative – or more specifically barrier options – which as the name suggests are an option consisting of a knock-in and a knock-out component. They have become increasingly more common around the world as a traded derivative due to the lower premium paid than on a vanilla option (a result of the unique dual barrier model) which has recently led to disaster for many businesses in South Korea.
Much like any other option, a KIKO can be traded as either an American or European option and can cover a range of underlying assets – from share to foreign exchange prices and anything in between. Unlike a vanilla (standard) option, however, a KIKO only operates within a specified window of spot prices; that is to say the option will only become active once a certain market spot rate is reached (knock-in) and will be voided if another spot rate is reached (knock-out) before maturity. Note that these two price levels can be either above or below the spot price (though in a KIKO the knock-in and knock-out events must be opposites) (Hull 2002). These specific spot rates are known as the barrier levels and a crossing of this barrier is known as a barrier or trigger event (New York Fed. 2000 and Cheng 2003). For a KIKO to become active it must first be knocked in; however, a knock-out event can occur at any time before the options maturity.
For example: an individual believes that the price of a specific share, which is currently $10, will rise, so they purchase a European call option with an exercise price of $10.50. This means that the person believes the price of the stock will rise by at least $0.50/share + premium paid. However, if this person also believes that the price of the stock...
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