The Analytics of Reset Options (Cheng, Zhang, 2000, The Journal of Derivatives)

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The Analytics of Reset Options
RM
WAI-YAN CHENG AND SHUGUANG ZHANG
FO
Y
AN
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IN
E
WAI-YAN CHENG The authors study a new type of path-depen- The warrant strike price was to be reset to
CL
is an assistant professor dent option called a reset option. On each of a set $39.76 should the stock price fall below
in the department of
of prespecified dates, the strike price of a reset option $39.76 on August 5, 1997. A more recent
TI
economics and
finance at the City will be reset to the prevailing stock price if the option example comes from Taiwan. Grand Cath has
University of Hong
Kong in Hong Kong. options are examined. A closed-form pricing formula AR
is out of the money. Its relationships with other exotic two reset warrants listed on the Taiwan Stock
Exchange (Bloomberg 0522 TT, 0517 TT):
in terms of the multivariate normal distribution is
IS
SHUGUANG derived under the risk-neutral framework. • 0522 TT: The strike price will be
ZHANG
Analysis of the pricing and hedge parameter adjusted if the six-day average price of
TH
is an associate profes-
sor in the department formulas reveals a simple interpretation of the option 2323 TT falls below 2%, 4%, 6%, 8%, or
of statistics and and hedging difficulties around reset dates. Exten- 10% of the initial strike price (= $81) any
finance at the Univer- sion to the case of using geometric average as reset time during the first three months after
CE
sity of Science and trigger is also given. the warrant’s listing. The strike price
Technology of China
will be reset to $79.38 (2% of the initial
DU
in Anhui.
call option holder has the right to strike price), $77.76 (4%), $76.14 (6%),
A buy a stock at a prespecified price $74.52 (8%), $72.90 (10%), accordingly.

O
(strike price) at maturity. Investors • 0517 TT: The strike price (initial =
always want to buy the stock at a $57.25) will be reset to $52.65 if the
PR
better price. Hence there are path-dependent six-day average price of 2323 TT falls
options that allow the strike price to change. below $52.65 any time during the first
RE
A look-back option sets the strike price equal three months after issue of warrant.
to the lowest stock price in the option’s life for
a higher up-front premium. In Japan, resettable convertible bonds are
TO
We study here another kind of path- very popular among convertible arbitrage traders
dependent options: reset options. For a reset who believe their models can identify under-
option, on specified dates, the strike price valued issues. This type of exotic derivative drew
L
will be reset to the prevailing stock price if the public attention in 1997 when UBS announced
GA
option is out of the money. a huge trading loss (U.S. $190 million) on its con-
This type of reset feature has been vertible desk. Nelken [1998] explains why it is
LE
applied in derivative products for many years. more difficult to hedge resettable options.
In the Asia Pacific region, Morgan Stanley Gray and Whaley [1997, 1999] describe
IL
issued a warrant in early June 1997 on the other products with other reset features such
Hong Kong stock, New World Development, as S&P 500 index bear market warrants with
IS
with an initial strike price equal to $44.73. a three-month reset. These warrants are traded
FALL 2000 THE JOURNAL OF DERIVATIVES 59

IT
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on the Chicago Board Options Exchange (CBOE) and I. COMPARISON WITH
the New York Stock Exchange (NYSE). Another exam- OTHER EXOTIC OPTIONS
ple is Geared Equity Investment (GEI), which has been
marketed by Macquarie Bank in Australia. The reset option, as defined in (1) and (3), appears
There are only a few articles studying reset options to be a brand-new type of exotic option. We study this
in the academic literature. Gray and Whaley [1997, 1999] relationship to other exotic options, using call options for
derive a pricing formula for reset options with one reset the sake of simplicity.
date. Reset options are related to discrete look-back There is a clear link between reset options and dis-
options, which have been studied in Heynen and Kat crete monitoring look-back options where the strike is
defined as
[1995]. Our result is similar to theirs, but our derivation

is quite different and forms a basis for extensions to other
forms of reset triggers. K(tn) = min[S(t1), . . . , S(tn)] (5)

Our main objective is to analyze general reset options
with n reset dates. More precisely, let (0 < t1, . . . , tn < T) Compared with (2), (5) has one fewer minimum candi-
be the set of reset dates, and K(ti) be the strike price at time date, K, the original strike price. The reset option price
ti (set t0 ≡ 0 and K(t0) ≡ K, the original strike price). For is higher than the price of the corresponding discrete look-
call options, the reset procedure is described by back option since the strike price of the reset option is
never higher. For reset options, the highest possible strike
investors will pay at the end is the original strike K. We
K(ti −1 ) if S(ti ) ≥ K(ti −1 ) (strike unchanged)
 cannot make such a statement about discrete look-back
K(ti ) =  options because the investor could face a high strike price
S(ti ) if S(ti ) < K(ti −1 ) (strike reset) if S(t1) turns out to be very high.
(1) It is sometimes easy to confuse reset options with a
combination of knock-out and knock-in options. Let
for 1 ≤ i ≤ n. Cout(S(t0), K, H) and Cin(S(t0), K, H) be knock-out and
Therefore knock-in options with current stock price S(t0), strike
--->
price K, and barrier H.
K(ti) = min[K(ti–1), S(ti)] The in/out combination (I/O) is defined as
It Is Illegal To Reproduce This Article In Any Format.

and as a result Cout(S(t0), K, H) + Cin(S(t0), K*, H)
K(ti) = min[K, S(t1), ..., S(ti)] (2) Hence the I/O combination will reset its strike to K* the
first time the stock price hits H, while reset options can
Similarly, the strike price of reset put options is do so only at specified times. A closed-form pricing for-
defined by mula for the I/O combination can be easily derived from
the formula for barrier options (see, for example, Zhang
[1997]). Recently, the I/O combination has been applied
K(ti −1 ) if S(ti ) ≤ K(ti −1 ) (strike unchanged)
 to study the “repricing” of executive stock options (see
K(ti ) =  Brenner, Sundaram, and Yermack [2000].
S(ti ) if S(ti ) > K(ti −1 ) (strike reset) Another similar exotic option is called cliquet (or
(3) click) option. A cliquet option is a strip of forward-start-
ing call options that run consecutively over the life of the
Hence option. Users have to specify a set of reset dates, and at
each reset date the cliquet option is reset at the money (to
K(ti) = max[K(ti–1), S(ti)] the prevailing stock price). The gains accrued in the pre-
vious periods are locked in on the reset dates. More pre-
and consequently cisely, the payoff of a cliquet option is given by
K(ti) = max[K, S(t1), ..., S(ti)] (4)
60 THE ANALYTICS OF RESET OPTIONS FALL 2000

n +1 The no-arbitrage price of the reset option is
+
∑ [S(ti ) − S(ti −1 )]
i =1
n
e−rT E[ξ ] = e−rT ∑ E[ ηi ] + e−rT E[ η] (8)
where (t1, . . . , tn) is the set of reset dates, t0 is the valu- i =1
ation date, and tn + 1 is the maturity date.
The pricing formula for forward-starting options can where
be found in Zhang [1997]. It follows from the simple ηi = [S( T) − S(ti )]+ I {S( t i ) = min[ K,S( t1 ),S( t 2 ),...,S( t n )]}
inequality (a + b)+ ≤ a+ + b+ that a cliquet option is always
more expensive than a reset option. A cliquet option offers
η = (S( T) − K)+ I {K = min[ K,S( t1 ),S( t 2 ),...,S( t n )]}
a better alternative to rolling over plain vanilla options (9)

after every reset period in terms of position administration.

Some of the products in the market like the Tai- We state the pricing formula for reset call options in
wanese reset warrants do not belong completely to any Theorem 1:
one of the exotic option families we just described. Our Theorem 1: For 1 ≤ i ≤ n:
reset option model clarifies a common reset feature found
in many derivative products. The reset features can be e–rTE[ηi] = S(t0)N(c0, ..., ci–1, Σi) ×
combined with other exotic structures to engineer more _
customized investment products for investors. [N(ci+1, ..., cn+1, Σi) – e–r(T–ti) ×
_
II. VALUATION OF n RESET DATE OPTIONS N(c^ i+1, ..., c^ n+1, Σi)] (10)
We provide the valuation formula for a reset option. and

Proofs for the call option case are given in Appendix A.
~
We assume throughout that the underlying financial mar- e–rTE[η] = S(t0)N(d1, ..., dn+1, Σ ) –
ket has one risk-free asset and a risky asset whose price
^ ^ ~
Ke–rTN(d 1, ..., d n+1, Σ )
--->
processes are given by (11)
dS0t = rS0tdt Therefore the price of an n reset date call option is given by

dSt = St(µdt + σdWt) (6) C = e−rT E[ξ ] =
where r, µ, and σ > 0 are constants, and Wt is a standard n

Brownian motion. By the risk-neutral valuation princi- ∑ [S(t0 )N(c0 , ..., ci −1 , ∑i ) ×
i =1
ple, we can assume that (under some special probability
measure) the return of the risky asset µ is equal to r in (N(ci +1 , ..., cn +1 , ∑i ) − e−r ( T − t i )N[ˆci +1 , ..., cˆ n +1 , ∑i ])] +
pricing derivatives. Let ξ be the payoff of a reset option
with n reset dates t1, . . . , tn. For notational convenience, ˜ ) − Ke−rT N(dˆ , ..., dˆ , ∑ ˜)
S(t0 )N(d1 , ..., d n +1 , ∑ 1 n +1
we define t0 = 0 and tn + 1 = T . (12)
By (2), we have
ξ = [S(T) − K(tn )]+ where N(•, Σ) is the cumulative normal distribution with mean
vector 0 and covariance matrix Σ. For each i, the parameters in
n (10) are defined as follows:
= ∑ [S(T) − S(ti )]+ I{S( t i ) = min[ K,S( t1 ),S( t 2 ),...,S( t n )]} +
i =1
(S(T) − K)+ I{K = min[ K,S( t1 ),S( t 2 ),...,S( t n )]}

(7)

 S(t )  σ2   S(t0 )  σ2 
− ln 0 +  r +  ti  ln +  r +  tk
 K  2  K  2
c0 = dk =
σ ti σ tk
(13)
(17)
 σ2  S(t )  σ2 
−  r +  (t i − t k ) ln 0 +  r −  tk
 2 K  2
ck = for 1 ≤ k ≤ i – 1 dˆ k =
σ ti − tk σ tk
for 1 ≤ k ≤ n + 1, and
 σ2 
 r + (t k − t i ) ~ _
 2  Σ = Σ0 (18)
ck =
σ tk − ti
The corresponding result for put options is given in
Theorem 2:
 σ2  Theorem 2: For an n-reset date put option, the price is
 r − (t k − t i )
 2  given by
cˆ k = (14) n
σ tk − ti P = e−rT ∑ E[(S[ti ] − S[T ])I{S( t i ) = max[ K,S( t1 ),S( t 2 ),...,S( t n +1 )]} ] +
i =1
for i + 1 ≤ k ≤ n + 1.
The covariance matrices e−rT E[(K − S[T ])I{K = max[ K,S( t1 ),S( t 2 ),...,S( t n +1 )]} ]
n
∑i = ( ∑ijk )1≤ j,k ≤i = ∑ [S(t0 )N(h0 , ..., hi −1 , ∑i ) ×
--->
i =1
and (e−r ( T − t i )N(hi +1 , ..., hn +1 , ∑i ) − N[hˆ i +1 , ..., hˆ n +1 , ∑i ])] +

∑i = ( ∑ ijk )1≤ j,k ≤n − i +1 Ke−rT N(g 0 , ..., g n +1 , ∑0 ) − S(t0 )N(ˆg 0 , ..., gˆ n +1 , ∑0 )
(19)
are given by
where for each i:
ti − tk −1
∑ijk = for 1 ≤ j, k ≤ i (15)
ti − t j −1  S(t )  σ2  
 ln
0
+ r + ti 
 K  2  
h0 =
σ ti
ti + j − ti
∑ ijk = for 1 ≤ j, k ≤ n + i − 1 (16)
ti + k − ti  σ2 
 r + 2  (t i − t k )
 
hk = for 1 ≤ k ≤ i − 1
In addition: σ ti − tk (20)

 σ2  E[S(ti )I {S( t i ) = K( t n +1 )} ] =
 r − (t k − t i )
 2 
hk = −
σ tk − ti E[S(ti )I {S( t i ) = K( t i )}I {S( t i ) = K( t i +1 , t n +1 )} ] =
 E[S(ti )I {S( t i ) = K( t i )} ]E[I {S( t i ) = K( t i +1 , t n +1 )} ] (24)

σ2 
 r + (t k − t i )
 2 
hˆ k = − (21)
Here we have extended the expression of K(tn) in
σ tk − ti
Equation (2) as:

for i + 1 ≤ k ≤ n + 1. K(tj, tn) = min[K, S(tj), . . . , S(tn)]

In addition:
for j ≥ 1 and hence K(tn) = K(t1, tn). Combining (23) and
(24), we get
S(t0 )  σ2 
ln +  r −  tk
K  2
gk = −
σ tk [
E[ ηi ] = E S(ti )I {S( t i ) = K( t i )} × ]
 S( T)  
S(t )  σ2  E  − 1 I {S( t i ) = K( t i +1 , t n +1 )}  (25)
ln 0 +  r +  tk
K  2  S(ti )  
gˆ k = −
σ tk (22) The events {S(ti) = K(ti)}, {S(ti) =K(ti+1, tn+1)} in
_ (25) describe the path constraints at S(tk), 1 ≤ k ≤ n + 1,
for 1 ≤ k ≤ n + 1, and the covariance matrices Σi, Σ i are the and can be written explicitly as {S(ti) ≤ S(tk), k ≤ i},
--->
same as those given in Theorem 1. {[S(tk)/S(ti)] ≥ 1, i + 1 ≤ k ≤ n + 1}, respectively. Because
We sketch the proof to facilitate analysis of the pric- S(t) follows a lognormal distribution, (25) can be com-
ing formula. First of all, from (9), we have puted in terms of a multivariate normal distribution func-

tion (details of the derivation are given in Appendix A).
[
E[ ηi ] = E (S[ T ] − S[ti ])+ I {S( t i ) = K( t n )} ] III. ANALYSIS OF THE PRICING FORMULA
[
= E (S[ T ] − S[ti ])I {S( t i ) = K( t n +1 )} ] Since the payoff of a reset option according to (7)
is always greater than that of the equivalent plain vanilla
option, the price of the reset option is always higher.
It follows from the independent increment property Exhibits 1 and 2 compare Black-Scholes prices and reset
of Brownian motions that option prices with one, two, and three reset dates. A
graphical comparison appears in Exhibit 3.
E[S( T)I {S( t i ) = K( t n +1 )} ] = A closer look at Equation (12) reveals that the price
of reset options is the sum of n + 1 components. Each of
the first n components is the discounted value of (25),
 S( T)  which, we will argue, is some sort of forward start option.
E S(ti ) I {S( t i ) = K( t i )}I {S( t i ) = K( t i +1 , t n +1 )}  =
 S(ti )  In fact, if we ignore the integration domain constraints in
(25), the expectation would become
 S( T) 
[ ]
E S(ti )I {S( t i ) = K( t i )} E 
 S(ti )
I {S( t i ) = K( t i +1 , t n +1 )} 
 (23)

EXHIBIT 1 EXHIBIT 2
Comparison of Black-Scholes Comparison of Black-Scholes
Prices and Reset Option Prices Prices and Reset Option Prices
n n
S(t0) σ r 0 (= BS) 1 2 3 S(t0) σ r 0 (= BS) 1 2 3
80 10% 5% 5.5535 10.1037 11.8929 13.7743 80 10% 10% 14.4771 17.7646 19.4900 21.7656
90 11.6580 14.0729 15.1884 16.4213 90 23.4501 24.6115 25.3240 26.3847
100 19.6299 20.5763 21.0454 21.5146 100 33.1065 33.4078 33.5875 33.8354
110 28.7115 28.9973 29.1552 29.2696 110 43.0048 43.0658 43.0988 43.1340
120 38.3387 38.4085 38.4648 38.4817 120 52.9773 52.9874 52.9994 52.9933
80 20% 5% 11.9147 16.4185 18.3545 20.1564 80 20% 10% 19.2401 23.0603 24.7686 26.6342
90 18.0602 21.3213 22.8217 24.1682 90 27.0908 29.5778 30.7549 31.9954
100 25.2133 27.4331 28.5349 29.4138 100 35.6621 37.1918 37.9485 38.6714
110 33.1497 34.5904 35.3617 35.8962 110 44.7245 45.6264 46.0920 46.4782
120 41.6731 42.5748 43.1060 43.4116 120 54.1134 54.6291 54.9065 55.1095
80 30% 5% 18.1639 22.9438 25.0726 26.8705 80 30% 10% 24.5440 28.7403 30.6120 32.3776
90 24.5732 28.4800 30.3235 31.7907 90 32.1047 35.3729 36.8997 38.2739
100 31.6491 34.7724 36.3268 37.4728 100 40.2085 42.7061 43.9261 44.9399
110 39.2707 41.7284 43.0219 43.9014 110 48.7312 50.6156 51.5766 52.3078
120 47.3355 49.2478 50.3190 50.9674 120 57.5767 58.9863 59.7421 60.2656
80 40% 5% 24.2320 29.2258 31.4894 33.2864 80 40% 10% 29.8614 34.3014 36.2961 38.0212
90 30.9531 35.3054 37.3747 38.9391 90 37.4277 41.1919 42.9575 44.4088
100 38.1599 41.9143 43.7834 45.0996 100 45.4082 48.5736 50.1203 51.3094
110 45.7717 48.9882 50.6649 51.7676 110 53.7228 56.3714 57.7197 58.6870
120 53.7217 56.4651 57.9682 58.8762 120 62.3082 64.5182 65.6884 66.4676
80 50% 5% 30.0637 35.1521 37.4820 39.2449 80 50% 10% 35.0375 39.5892 41.6472 43.3140
--->
90 37.1060 41.7202 43.9225 45.5139 90 42.7303 46.7843 48.6888 50.1631
100 44.5209 48.6810 50.7421 52.1631 100 50.7477 54.3432 56.0939 57.3829
110 52.2490 55.9862 57.9122 59.1599 110 59.0322 62.2136 63.8196 64.9369

120 60.2421 63.5924 65.3894 66.4951 120 67.5385 70.3507 71.8196 72.7813
80 60% 5% 35.6118 40.6739 42.9987 44.7073 80 60% 10% 39.9937 44.5370 46.6021 48.1935
90 42.9700 47.6854 49.9423 51.5126 90 47.8667 52.0456 54.0165 55.4707
100 50.6225 54.9982 57.1587 58.6107 100 55.9992 59.8326 61.6983 63.0143
110 58.5236 62.5747 64.6473 65.9761 110 64.3474 67.8592 69.6239 70.8127
120 66.6366 70.3825 72.3553 73.5647 120 72.8773 76.0929 77.7526 78.8376
n is the number of reset dates. Reset dates are (2) for one reset date, n is the number of reset dates. Reset dates are (2) for one reset date,
(1.5, 3) for two reset dates, and (1, 2, 3) for three reset dates. K = 100, (1.5, 3) for two reset dates, and (1, 2, 3) for three reset dates. K = 100,
T = 4, r = 5%. T = 4, r = 10%.
 S( T)  +  The price of a forward start option is (see Zhang

E[S(ti )]E  − 1  = E[(S[ T ] − S[ti ])+ ] [1997, p. 186]):
 S(ti )  
  ^
S(t0)exp(rti)[N(d) – exp[–r(T – ti)]N(d )] (26)
which is the payoff of the forward start (at time ti) at-the-
money option.

EXHIBIT 3 Hedge parameters (or Greeks) are important for
Comparison of Black-Scholes the risk management of reset options. We collect the
Price and Reset Option Prices formulas for delta and gamma in Theorem 3. The other
Greeks can be similarly derived. For notational conve-
nience when differentiating the normal distribution, we
define:
2 reset times ^
_
1 reset times N (x) = N(xi+1, ..., xn+1, Σi)
Black Scholes
~
N (x) = N(x0, ..., xi, Σi)
~
N(x) = N(x1, ..., xn+1, Σ )
Theorem 3. The delta and gamma of reset call options are

given as follows.
∂C(S)
∆call (S0 ) = =
∂S S = S 0
n +1
1 ∂N(d ) −rT K n +1 1 ∂N(dˆ )
Reset times are 1 for one reset time, (1, 2) for two reset times (K = N(d ) + ∑ −e ∑ +
100, T = 3, σ = 30%, r = 5%). k =1 σ t k ∂x k S0 k =1 σ tk ∂x k
n  1 ∂N ˜ (c) 
∑ [Nˆ (c) − e−r ( T − t k )N
 (c) −
ˆ (cˆ)] N˜

where k =1  σ tk ∂x 0 
--->
(27)
 σ2 

 r + ( T − ti ) ∂ 2C(S)
 2  Γ call (S0 ) = =
d= ∂S2 S =S 0
σ T − ti
1 n +1 1 ∂N(d ) 1 n +1 1 ∂ 2N(d )
 σ2  ∑ + ∑ 2 +
r − ( T − ti ) S0 k =1 σ tk ∂x k S0 k , l =1 σ tk t l ∂x k ∂x l
 2 

dˆ =
σ T − ti K n +1
1 ∂N(dˆ ) K n +1 1 ∂ 2N(dˆ )
e−rT ∑ − e−rT 2 ∑ 2 +
S02 k =1 σ tk ∂x k S0 k , l =1 σ tk t l ∂x k ∂x l
Equation (26) can be viewed as a product of two fac-
tors. The first is the expected stock price at time ti, n
ˆ (c) − e−r ( T − t k )N 1 1 ∂N ˜ (c) ˜ (c) 
1 ∂ 2N
E[S(ti)], and the second is an at-the-money option with ∑ [N ˆ (ˆ)]
c − + 2 
respect to the stock price at ti. It is reasonable to say that k =1 S0  σ tk ∂x 0 σ tk ∂x 02 
ηi is a forward start option at ti, conditional that S(ti) is the (28)
minimum among (S(t1), . . . , S(tn), K). η is a call option
struck at K with the extra condition that K = min(S(t1), where c and ^c are as defined in Equation (14).
. . . , S(tn), K). Hence the price of the reset option is the The delta and gamma of reset put options are
sum of a series of conditional forward start options at ti
plus the price of a conditional call option struck at K.

∂P(S) EXHIBIT 4
∆put (S0 ) = = Delta of Plain Vanilla and Reset Options
∂S S = S 0
K n +1 1 ∂N(g) n +1
1 ∂N(gˆ )
−e−rT ∑ − N(gˆ ) + ∑ +
S0 k =1 σ tk ∂x k k =1 σ t k ∂x k
 ˜ 
˜ (h) + 1 ∂N(h)
n
∑ [e − r ( T − t k ) N ˆ (hˆ )] N
ˆ (h) − N
 
σ tk ∂xx 0 
k =1 
(29)
∂2 P(S)
Γ put (S0 ) = =
∂S2 S =S 0
K n +1 1 ∂N(g) −rT K n +1 1 ∂2N(g)

e−rT ∑ + e ∑ +
S20 k =1 σ tk ∂x k S20 k , l =1 σ2 tk t l ∂x k ∂x l
Reset times are 1 for one reset time, (1, 2) for two reset times (K =
1 n +1 1 ∂N(ˆ) g 1 n +1 1 ∂2N(ˆ)g 100, T = 3, σ = 30%, r = 5%).
∑ − ∑ 2 +
S0 k =1 σ tk ∂x k S0 k , l =1 σ tk t l ∂x k ∂x l
assuming there is only one reset date t1, the delta at t ≥ t1 is
n  1 ∂N ˜ (h) ˜ (h) 
1 ∂ 2N
∑ [e −r ( T − t k ) ˆ (hˆ )] 1
ˆ (h) − N +
N  
--->
k =1 S0  σ tk ∂x 0 σ tk ∂x 20 
2
(30)  x +2
− 1
1
∆(t, St ) = I{S t ≥ K} N( x1 ) + 2
+

e 2 −
^ 1  σ (T − t )
where g, g^ , h, and h are as defined in Equations (21) and (22). 
An interesting fact about reset option deltas can be
observed from (27). Recall that for plain vanilla options,
−
x 1−2 
∆(S) → 0 as S → 0. This is not the case for reset options. K 1 +
e − r ( T − t) e 2
In fact, as S0 → 0, the reset option delta tends to S t σ (T − t )
2 

n
ˆ (c) − e−r ( T − t k )N
∑ [N ˆ (cˆ)]N
˜ (c) >0
k =1 c 0 =∞
 x +2
− 2
1
which reminds us to hedge even when the stock price is I{S t < K} N( x 2 ) + 2
+
e 2 −
1  σ (T − t )
0. This is because there is a high chance the option will 
be reset. The deltas for different reset options are plotted
in Exhibit 4. x −2 2 
St 1 1 −
The main problem in hedging reset options is the pos- e − r ( T − t)
e 2  (31)
sible jump of delta across reset dates. The delta will be S t σ 2 (T − t ) 
pulled up close to the delta of an at-the-money option if the 
option is actually reset at the reset date. More precisely,

with order to derive an approximate pricing formula for the
arithmetic average option price.
Second, the geometric average reset option price can
St  σ2  be used as a control variate in the Monte Carlo simula-
ln +  r ±  ( T − t) tion for the arithmetic average reset. This technique is used
K  2
x1± = to study the arithmetic average option in Kemna and
σ T−t Vorst [1990]. With a closed-form formula derived below
for the geometric average case, we believe these two
St  σ2  approaches could yield accurate numerical results for the
ln +  r ±  ( T − t)
St 1  2 arithmetic average reset options.

x 2± = We consider the case of one reset date t1. Define the
σ T−t payoff of reset options by geometric averages as

By (27), one can show that, for St ≥ K:
1
lim ∆(t, St ) = ∆(t1 , St1 ) 64444 ζ 1 strike reset
4744444 8 6444 ζ 2 strike not reset
74444 8
t➚t1 + +
ζ = [S( T) − A(h; t1 )] I {A (h; t1 ) < K} + [S( T) − K ] I {A (h; t1 ) ≥ K}
but not the case for St < K. How to handle delta dis- (32)
1
continuities across reset dates is a important question.
This issue is the subject of future research. One possible where the geometric average of the stock price S(t) is
approach is to apply combinations of forward start options given by
to “static” hedge the reset options.
1 
IV. AVERAGE TRIGGER RESET OPTIONS A(h; t1 ) ≡ exp  ∫ tt1 − h ln S(u)du (33)
h 1

In many real-world financial products, averages of
stock prices are used as “triggers” in order to avoid price By the principle of risk-neutral valuation, the reset
--->
(hence strike) manipulation. Basing option payoffs on option price is given by
the average of stock prices is not new in the derivatives
industry. Asian options have proven to be very popular e–rTE[ζ] = e–rTE[ζ1 + ζ2]

path-dependent options and receive a lot of attention in
academic research. The majority of Asian options traded Theorem 4 gives the pricing formula for geomet-
in the OTC market use arithmetic averages to define ric average reset options:
their payoffs. The same applies to average trigger reset Theorem 4: Given t1 < T and defining the payoff ζ of
options. Both Taiwanese reset warrants and Japanese con- the geometric average reset option according to (32) and (33), the
vertibles use arithmetic averages as triggers. price of the reset option is given by
Since the arithmetic average option has no closed-
form solution, it is equally difficult to derive a closed-form ∨
formula for the arithmetic average reset option. Many e−rT E[ζ ] = S(t0 )N(e1 , e2 , ∑) −
attempts have been made to approximate values of arith-
metic average options using the closed-form pricing for- ∨ ′
mula of geometric average options. For a survey of these Ke−rT N(eˆ1 , eˆ 2 , ∑) + S(t0 )N( f1 , f 2 , ∑) −
results, see Zhang [1997].
 h
Although a more thorough study of arithmetic aver- − r  T − t1 + 
 2
 σ2 5h  ′
age reset options is left for future research, we can define S(t0 )e exp  N( f 3 , f 4 , ∑)
the corresponding geometric average reset option and  2 6
derive its pricing formula. This result is useful for two rea- (34)
sons. First, as described in Theorem 6.1 of Zhang [1997], ∨ ′
the geometric average of stock prices can be “scaled” to where e1, e2, ∑, e^1, e^2, f1, f2, ∑, f3, and f4 are defined as
approximate the arithmetic average of stock prices in follows:

S(t0 )  σ2   h  h
ln +  r −   t1 −  − σ2  t1 + 
S(t0 )  2
σ  h K  2  2  3
ln +  r +   t1 −  f3 =
K  2   2
e1 = h
σ t1 +
h 3
σ t1 +
3
 σ2   h 2 5h
 r −   T − t1 +  − σ
S(t0 )  σ 2
 2  2 6
ln + r +  T f4 = (39)
K  2
4
e2 = (35) σ T − t1 + h
σ T 3
S(t0 )  σ2   h  5 
ln +  r −   t1 −  
h

K  2  2 1 6
eˆ1 =  
 4 h
h T − t1 + h t1 + 
σ t1 +  3 3  (40)
3 ′
∑= 
 5 
S(t0 )  σ2   h 
ln + r −  T  6 1 
K  2 (36)  
eˆ 2 = 4 h
 T − t1 + h t1 + 
σ T  3 3 
The proof of Theorem 4 is given in Appendix B.

 h 
t1 −
 2 
--->
 1  V. SUMMARY
 h
T t1 + 
 3 We have defined the general n reset date option. Its

∨
∑=  (37) relationships with other exotic options are explored. We
 h  derive pricing formulas for the general reset option and
 t1 − 
 2  a one-reset date geometric average reset option.
1
 h  In future investigations, we plan to study other
 T t1 +  forms of reset triggers such as arithmetic averages and
 3 
devise better hedging methods across reset dates to han-
dle the possible discontinuities of delta.
 S(t )  σ2   h 
−  ln 0 +  r +   t1 −   APPENDIX A
 K  2  2 
f1 =   = −e Proof of Theorem 1
1
h
σ t1 + To compute the expectations in (23) and (24), we need
3 to break the evolution of stock price on [0, T] into subinter-
vals [tk, tk+1] for k = 0, ..., n so that the integration domains can
 σ2   h be written in terms of the random variables defined on those
 r +   T − t1 +  intervals. More precisely, given a time sequence {tk, 0 ≤ k ≤ i},
 2  2
f2 = (38) we define
4h
σ T − t1 + Xk = σ(Bt – Bt )
3 k k–1

for 0 ≤ k ≤ i. Notice that {Xk, 1 ≤ k ≤ i} are independent and The integration variable is then changed to yi ≡ xi – σ2∆ti and
follow a normal distribution with mean 0 and variance σ2(tk – a new random variable:
tk–1). Since S(t) follows a lognormal distribution with risk-free
interest rate r and volatility σ, we have, for any k ≤ i: Yi
Ui =
σ ∆ti
 1   k 
S(tk ) = S(t0 )exp  r − σ2  tk  exp  ∑ X j  (A-1)
 2    j =1  is defined so that the {Ui} are independent and follow a stan-
dard normal distribution. Therefore:
where S(t0) is the initial stock price.
The integration domain I{S(t )=K(t )} in (23) can be written

i i
E[S(ti )I{A 0 ∩ A 1 ∩...∩ A i −1 } ] =
in terms of {Xk, 0 ≤ k ≤ i} as follows:

( u 12 +⋅⋅⋅+ u i2 )
1 −
S(t0 )exp(r ti ) ∫⋅⋅⋅ ∫ e 2 du1 ⋅ ⋅ ⋅ dui
 i K  σ2   A 0 ∩ A 1 ∩...∩ A i −1 (2 π)i / 2
A 0 ≡ {S(ti ) ≤ K} =  ∑ X j ≤ ln −  r −  ti 
 j =1 S(t0 )  2  (A-3)

and Ak are represented in terms of Ui:
 i  σ2  
A k ≡ {S(ti ) ≤ S(tk )} =  ∑ X j ≤ − r −  (ti − tk )
 j = k +1  2 
 i K  σ2  
A 0 ≡ {S(ti ) ≤ K} = σ ∑ ∆t j U j ≤ ln −  r +  ti 
for 1 ≤ k ≤ i – 1.  j =1 S(t0 )  2 

We are ready to compute the first expectation
 i  σ2  
E[S(ti )I {S( t i ) = K( t i )} ] = E[S(ti )I {A 0 ∩ A 1 ∩...∩ A i −1 } ] A k ≡ {S(ti ) ≤ S(tk )} = σ ∑ ∆t j U j ≤ − r +  (ti − tk )
 j = k +1  2 
of (23). Recall that the joint probability density function p(x1, for 1 ≤ k ≤ i – 1.
--->
..., xi) of (X1, ..., Xi) is given by Our last step is to define Ak in terms of only one random
variable so that the final answer is given in terms of multivari-
ate normal distribution functions. To do so, we introduce

1 i  x 2j  another random variable:
∏ exp − 2 
 
(2 π)i / 2 σi ∏ij =1 ∆t j j =1  2σ ∆t j 
1 i
Zk = σ∑ ∆t j U j
σ ti − tk −1 j=k
with ∆tj ≡ tj – tj–1.
It follows from (A-1) that
for k = 1, . . . , i.
E[S(ti )I{A 0 ∩ A 1 ∩...∩ A i −1 } ] = It follows that Var(Zk) = 1 and for l < m:
 1   1 1
S(t0 )exp  r − σ 2  ti  ∫⋅⋅⋅ ∫ ex 1 +...+ x i p( x1 , ..., x i )dx1 ⋅ ⋅ ⋅ dx i Cov(Z l , Z m ) =
 2   A 0 ∩ A 1 ∩...∩ A i −1 ti − t l −1 ti − tm −1
(A-2)
 i i  ti − tm −1
Cov ∑ ∆t j U j , ∑ ∆t j U j  = (A-4)
To evaluate the integral in terms of a normal distribution,  j= l j=m  ti − t l −1
we apply a few changes of variables. First, we complete the
square for the xi terms as follows: which gives the covariance matrix Σ defined by (15). It is clear
that Ak = {Zk+1 ≤ ck} for 0 ≤ k ≤ i – 1 where ck are defined in
 x2   ( x − σ2 ∆t )2   σ∆ti  (13). Therefore we obtain the formula:
exp( x i )exp − 2i  = exp − i 2 i  exp 
 2σ ∆ti   2σ ∆ti   2 

E[S(ti )I {A 0 ∩ A 1 ∩...∩ A i −1 } ] = S(t0 )ert i N(c0 , c1 , ..., ci −1 , ∑) (A-5) Lemma B.1. Let Bt be the Brownian motion. Define random
variable X by
The other terms in (23), (24), and E[η] can be computed

1 t1
by essentially the same argument. This completes the proof of X≡ ∫ B u du
Theorem 1. ⵧ h t1 − h
where X follows a normal distribution with mean 0 and variance

APPENDIX B t1 + (h/3).
Proof of Theorem 4 Lemma B.2. Let t1 < T. The covariance between X and Y is
t1 – (h/2).
We first compute the expectation of ζ2: As a result, the correlation coefficient between X and Y is
E[ζ2 ] = E[(S( T) − K)I {A (h; t1 ) ≥ K;S( T ) ≥ K} ]

h
t1 −
= E[(S( T)I {A (h; t1 ) ≥ K;S( T ) ≥ K} ] − K P[ A(h; t1 ) ≥ K; S( T) ≥ K ] ρ = ρ XY = 2
14444244443 14444244443 h
I1 I2 T t1 +
3
(B-1)
Observe that We compute I1 using the joint probability density func-

tion of the bivariate normal distribution:
1 
A(h; t1 ) = exp  ∫tt1 − h ln S(u)du  σ 2  
 h 1
 I1 = S(t0 )exp  r −  T
1
×
 2   2π 1 − ρ2 σ σ
 X Y
1  σ2  1 
= S(t0 )exp  ∫tt1 − h  r −  udu + σ ∫tt1 − h B u du
 h 1
 2 h 1
  1  x2 2ρxy y2  
∫ ∫ exp(σy)exp − − +  dxdy
--->
 2 
 2(1 − ρ )  σ X σ X σ Y σ Y  
2 2
R1 ∩ R 2
 σ2   h  (B-3)
= S(t0 )exp  r −   t1 −  + σX 
 2  2 

(B-2) where
where  K  σ2   h 
 ln −  r −   t1 −  
 S(0)  2  2 
R1 ≡ {A(h; t1 ) ≥ K} = x ≥ 
1 t1  σ 
X≡ ∫ B u du  
h t1 − h  
For simplicity, we denote the random variable BT by Y,  K  σ2  

and hence  ln − r −  T 
 S(0)  2 
R 2 ≡ {S( T) ≥ K} = y ≥ 
 σ 
 σ2    
S( T) = S(t0 )exp  r −  T + σY   
 2 
In order to write I1 in terms of normal distribution func-
tions, we follow the same procedures as before: Complete the
The integral I1 will be computed in terms of X and Y.
square for terms with variable y, parallel-shift the integration
As a result, we need the statistical properties of X and Y,
variables, and normalize the random variables at the end. The
which are given in the lemmas below. The proofs of these lem-
completing square part is a bit different, and Lemma B.3 is use-
mas are standard in probability theory (and not included here
ful in dealing with the algebraic operations:
for space reasons).

Lemma B.3. For any constant a, b, we have: REFERENCES
Brenner, M., R.K. Sundaram, and D. Yermack. “Altering the

 1  x2 2ρxy y2   Terms of Executive Stock Options.” Journal of Financial Eco-
exp(ax + by)exp −  − + 2 
= nomics, 57 (2000), pp. 103-128.
 2(1 − ρ )  σ X σ X σ Y σ Y  
2 2
Gray, S., and R. Whaley. “Reset Put Options: Valuation,

 Cov( W , W )   1  ( x − Cov[ X, W ])2 Risk Characteristics, and an Application.” Australian Journal of
exp  exp − 2 
− Management, 24 (1999), pp. 1-20.
 2   2(1 − ρ )  σ2X
——. “Valuing S& P 500 Bear Market Warrants with a Peri-

2ρ( x − Cov[ X, W ])( y − Cov[ Y, W ]) ( y − Cov[ Y, W ])2  odic Reset.” Journal of Derivatives, Fall 1997, pp. 99-106.
+ 
σXσY σ2Y 
(B-4) Heynen, R.C., and H.M. Kat. “Lookback Options with Dis-
crete and Partial Monitoring of the Underlying Price.” Applied
where Mathematical Finance, 2 (1995), pp. 273-283.
W = aX + bY Kemna, A.G.Z., and A.C.F. Vorst. “A Pricing Method for

Options Based on Average Asset Values.” Journal of Banking and
It follows that Finance, 14 (1990), pp. 113-129.
1 Nelken, I. “Reassessing the Reset.” Risk, October 1998, pp.

I1 = S(t0 )exp(rT) ×
2π 1 − ρ2 36-39.
 (u2 − 2ρuv + v2 )  Zhang, P. Exotic Options. Singapore: World Scientific Pub-

∫∫ exp −  dudv lishing, 1997.
R 1 ∩R 2  2(1 − ρ2 )  (B-5)
--->
with R1 = {u ≤ e1} and R2 = {v ≤ e2}. Therefore:
∨

I1 = S(t0)exp(rT)N(e1, e2, ∑ ) (B-6)
∨
with e1, e2, and ∑ as defined in (35). I2 and E[ζ2] can be com-
puted similarly. This completes the proof of Theorem 4. ⵧ
ENDNOTE
The authors thank Chengqing Wu for research assis-

tance and Ivan Wong for motivating this article. Prof. Zhang’s
research is supported by grant 79790130 of the National Sci-
ence Foundation of China. Prof. Cheng’s research is supported
by DAG 7100019-650 of City University of Hong Kong.

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The Analytics of Reset Options

A buy a stock at a prespecified price $74.52 (8%), $72.90 (10%), accordingly.

FALL 2000 THE JOURNAL OF DERIVATIVES 59

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[1995]. Our result is similar to theirs, but our derivation

forms of reset triggers. K(tn) = min[S(t1), . . . , S(tn)] (5)

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K(ti) = max[K, S(t1), ..., S(ti)] (4)

60 THE ANALYTICS OF RESET OPTIONS FALL 2000

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a better alternative to rolling over plain vanilla options (9)

after every reset period in terms of position administration.

We provide the valuation formula for a reset option. and

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where r, µ, and σ > 0 are constants, and Wt is a standard n

(S(T) − K)+ I{K = min[ K,S( t1 ),S( t 2 ),...,S( t n )]}

FALL 2000 THE JOURNAL OF DERIVATIVES 61

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and (e−r ( T − t i )N(hi +1 , ..., hn +1 , ∑i ) − N[hˆ i +1 , ..., hˆ n +1 , ∑i ])] +

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62 THE ANALYTICS OF RESET OPTIONS FALL 2000

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 E[S(ti )I {S( t i ) = K( t i )} ]E[I {S( t i ) = K( t i +1 , t n +1 )} ] (24)

Equation (2) as:

for i + 1 ≤ k ≤ n + 1. K(tj, tn) = min[K, S(tj), . . . , S(tn)]

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 S( T)  +  The price of a forward start option is (see Zhang

64 THE ANALYTICS OF RESET OPTIONS FALL 2000

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Theorem 3. The delta and gamma of reset call options are

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K n +1 1 ∂N(g) −rT K n +1 1 ∂2N(g)

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66 THE ANALYTICS OF RESET OPTIONS FALL 2000

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St 1  2 arithmetic average reset options.

σ T−t payoff of reset options by geometric averages as

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The proof of Theorem 4 is given in Appendix B.

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68 THE ANALYTICS OF RESET OPTIONS FALL 2000

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The integration domain I{S(t )=K(t )} in (23) can be written

in terms of {Xk, 0 ≤ k ≤ i} as follows:

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The other terms in (23), (24), and E[η] can be computed

where X follows a normal distribution with mean 0 and variance

E[ζ2 ] = E[(S( T) − K)I {A (h; t1 ) ≥ K;S( T ) ≥ K} ]

Observe that We compute I1 using the joint probability density func-

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For simplicity, we denote the random variable BT by Y,  K  σ2  

70 THE ANALYTICS OF RESET OPTIONS FALL 2000

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