Knock-in/Knock-out (KIKO) Options

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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... ... middle of paper ... ...ng Techniques for Professional Investors, 1st ed. McGraw Hill, New York Yeon-hee, K 2009 ‘S. Korea high court rejects suit to suspend FX option deals’ Reuters [internet] Aug 23 2009 Trade Practices Act 1974 ASIC Regulatory Guide 168 ‘Disclosure: Product Disclosure Statements (and other disclosure obligations)’ 2007 Securities and Exchange Commission [internet] Sep 22 2009 http://www.sec.gov/about/whatwedo.shtml Accessed 23/9/2009 Financial Services Authority, 2009 ‘The Responsibilities of Providers and Distributors for the Fair Treatment of Customers (RPPD)’ ACCC ‘Court orders corrective ads by Commonwealth Bank’ [internet] Dec 10 2003 http://www.accc.gov.au/content/index.phtml/itemId/420894 Accessed 23/9/2009 Wood, D 2009 ‘KO-ed in Korea’ AsiaRisk May 2009 pp. 16-19 Won-bae, K 2009 ‘High Court finds for KIKO sellers’ JoongAngDaily [internet] August 26 2009

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