With only minor adjustments to the contract details, the trading risks on European vanilla options can be significantly changed. The adjustments discussed in this chapter are late-delivery, American exercise, and self-quanto payoff.
Consider the options shown in Exhibit 27.1. Leg 1 is a standard European vanilla option with a 1yr expiry. Leg 2 is identical except that the delivery date is one year after the standard delivery date. For a European vanilla option with the standard delivery date, the price of a physically delivered option is the same as the price of a cash-settled option. However, for a late-delivery vanilla option the price difference can get large.
In practice, Exhibit 27.1 doesn't contain enough information to price the late-delivery option because these same contract details could represent three different derivative contracts. When pricing late-delivery options it is important to confirm exactly what payoff is required and understand what methodology the pricing model uses so any necessary additional adjustments can be made.
The late-delivery vanilla option in Exhibit 27.1 could be a late cash vanilla option. At maturity, the option is exercised against a fix. The option is then cash ...