A path dependent option is a situation where the price of the option is determin

Question

A path dependent option is a situation where the price of the option is determined by what the value of the asset is over the life of the terms of the contract, which can often fluctuate, rather than it being a single price at the end of the contract. One example of this can be determined when dealing with Mortgage Backed Securities, where there are interest rates that can fluctuate and will then determine what the price is based on those changes.

A path independent option is determined strictly by the terms of the contract and not over the fluctuations in the asset value over the life of the contract. In essence the final price of the contract. An example would be a European call option where the strike price is at $100 and if the amount goes over that amount they would benefit, since they are locked in at the set $100 price and would not have to pay more. If the amount was under that set amount there would be no need to exercise the option, as they can go out into the market and buy for less.

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Explanation / Answer

An option contract whose price is determined according to some formula involving the price of the underlying asset over time. Most options have prices that are dependent upon the value of the underlying asset at the time theoption is exercised. A path dependent option, on the other hand, uses a more complex formula. For example, insome Asian options, the strike price is the average of the prices of the underlying asset over the life of thecontract.

The right, but not the obligation, to buy or sell an underlying asset at a predetermined price during a specified time period, where the price is based on the fluctuations in the underlying's value during all or part of the contract term. A path dependent option's payoff is determined by the path of the underlying asset's price.

A basic American option is one type of path dependent option. Because it can be exercised at any time prior to expiration, its value will change as the underlying asset's value changes. An Asian option, also called an average option, is another type of path dependent option, because its payoff is based on the average price of the underlying asset during the contract term. Similarly, a barrier option would be considered a path dependent option because its value changes if the underlying asset reaches or surpasses a specified price. The lookback option and Russian option are also path-dependent options.

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