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   Compound Option
   















 

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Compound Option

A Compound Call Option (1)
(1) An option on an option, such as a put on a call, a call on a put, a call on a call, or a put on a put. These options are used primarily in fixed income and currency markets when the need for the risk protection afforded by an option is not certain and the buyer of the compound option would like to pay a reduced initial premium. The contingency on the first option usually determines the need for the protection provided by the second option. Compound option techniques are often useful in evaluating early exercise options and in a variety of fixed- income option valuation applications. Also called Option on an Option. See also Back Fee, Front Fee, Caption (diagram), Compound Average Rate Option, Floortion, Split-Fee Option, Strike Premium, Exotic Options. See also Cacall, Caput. (2) The term is occasionally used to refer to a call option on the shares of a leveraged company. Common shareholders, in effect, have a call option to 'buy' the firm by paying off its debt. Alternately, shareholders cannot lose more than the cost of their shares if they abandon the firm to the debt holders. Robert Geske and others have used such examples to demonstrate that a call option on common stock can be usefully valued as an option on an option.

Glossary * C