Rainbow Option

Rainbow option is a single option that has multiple underlying assets. For an investor dealing in rainbow option to make money, all the underlying assets must move in the same intended direction.

The underlying securities of a rainbow option have different characteristics, such as expiry date and strike price. All of the underlying assets must move in the way the option holder has bet they will in order to make profits.

Investopedia gave an analogy to demonstrate this type of an option. “Suppose you're at a baseball tournament with three fields backing one another. One game is halfway through, a second is just starting and a third starts in an hour. A type of bet that's analogous to a rainbow option is one that earns you a profit if you pick all three winners, but gets you nothing if any one team you pick is a loser".

http://www.investopedia.com/terms/r/rainbowoption.asp

When an investor foresees an N number of underlying assets to move in a certain direction, she can invest in put or call option. If the underlying assets do indeed move the way she expected, she can exercise her call/put option and make profits.

For instance, Jill expects that Caterpiller, John Deere, and Komatsu stock will plummet by about 10% in the next quarter. She gets excited at the prospect of selling off her Caterpillar stocks for a higher than market price and so she invests in put options that will allow her to sell caterpillar stocks at the current price in 3 months time. She also invests in put options for John Deere and Komatsu stocks that she does not own. If in 3 months time the results are what she expected, she can make a lot of money selling off her stocks for higher price than what they are worth. She can also make money by buying John Deere and Komatsu assets for low price and selling them off for higher price.

If the market moves in a different direction, i.e. if the stock prices of these companies go up instead of down, she will not make any money. Her investment in the put options will have been a loss.

Benefits of Rainbow Assets

Rainbow options are used to hedge the risk associated with multiple assets. Rainbow option is considered an excellent tool for hedging risks that arise from holding multiple assets.
Rainbow options are especially effective hedging tools when assets are negatively correlated. Suppose there are assets A and B that are negatively correlated. Further suppose that asset A is worse than B. A put on asset A provides protection from price movements in either direction.

http://www.fintools.com/doc/exotics/exoticsAbout_Rainbow_Options.html

Features of Rainbow Options

1. Rainbow option on positively correlated assets are less expensive than those on negatively correlated assets because lower the correlation between assets, higher the variability in their movements.

2. Rainbow options on two underlying assets are common, but such options on more than two underlying assets are less common and in general not analytically tractable.

Spread or outperformance options are examples of rainbow options.

http://financialriskmanagement.wikidot.com/rainb

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