A corporate treasurer is concerned at the high cost of the premium associated with establishing an options strategy. The company’s bank suggests that the use of a barrier knock-out option to protect against a rise in the spot exchange rate might be a cheaper alternative strategy.
(a) Explain how a barrier knock-out option is structured.
(b) Draw a fully labelled diagram showing the strategy.
(c) Using what you know about barrier knock-out options, briefly explain how these securities might contribute to the volatility of market prices. (LO 20.5)