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Abstract
In this article, two-color partial rainbow options (TCPROs) are proposed. Such options allow holders to choose between the two underlying vanilla options at a specified time before expiry. Examples of benefits of TCPROs to both holders and issuers are given. Pricing formulae for such options are derived. The extra premium due to the choosing feature of a TCPRO, called the price of choice, is a nonnegative decreasing function of the correlation coefficient of the two underlying assets and the remaining time to choose. Numerical results are obtained to show that while TCPROs are more valuable than the underlying vanilla options, their risk parameters such as delta and gamma are smaller.
Acknowledgments
Der-Chen Chang is supported by NSF grant No. DMS 9822249 and a William Fulbright Research Grant. Eric C. Chang is supported partially by a grant from the University Grants Committee of the Hong Kong Special Administrative Region, China (Project No. AoE/H-05/99). Haitao Fan is partially supported by NSF grant No. INT 0115131.