What it means
The key idea is a fixed payment triggered by an event. Unlike an ordinary option, whose payoff grows as the market moves in your favour, a rebate is a set sum.
It might be $2 per share or $50,000 in total, agreed in advance. In barrier options, the event is the underlying price touching a set level.
If the option is cancelled by that event, the rebate is paid as compensation. If it is a knock-in option that never switches on, the rebate may be paid at the end of its life.
There is no single standard definition of the phrase, so you will see it used in more than one way. Some writers treat it as a short name for a rebate barrier option.
Others use it for any contract in which a rebate forms part of the payoff, so always read the term sheet to see what is actually promised. The rebate matters for pricing.
Because the seller promises to pay it under some outcomes, it raises the cost of the option. The size of the extra cost depends on how likely the trigger event is, how big the rebate is and how far into the future it falls.
Finance teams should also think about accounting and risk. Derivatives are generally measured at fair value, and the rebate forms part of that value.
The contract also exposes the holder to the seller's ability to pay, so credit quality matters. Before buying, a company should ask its adviser to explain in plain language when the rebate is paid, how the trigger is measured and what happens if the market is closed or disrupted.
Small differences in wording can decide whether a rebate is paid or not. A clear scenario table in the board paper helps decision makers see all outcomes.
In practice
Real-world examples.
Example
A manufacturer buys a currency hedge with a rebate of $25,000 if the exchange rate crosses a barrier. The rebate tops up cash when the hedge ends early. The treasury team records the option at fair value each quarter.
Example
An investment bank sells a structured product to a client that includes a rebate option. If the underlying index never reaches a set level, the client receives a fixed payment at maturity. The bank prices the feature using the probability of the barrier being hit.
Example
A risk manager reviews a portfolio of options and finds that a $1,500,000 position has a rebate paid on cancellation. She models the rebate separately from the main option. This makes the total exposure easier to see.
Formula
Calculation
Present value of expected rebate = Probability of trigger x Rebate per unit x Number of units / (1 + discount rate) ^ years
Suppose a company holds options on 10,000 shares with a rebate of $2 per share, and estimates a 25% chance that the trigger event occurs within a year. The expected rebate is 0.25 x 2 x 10,000 = $5,000. With a discount rate of 5%, the present value is 5,000 / 1.05 = $4,762. This is the amount the rebate feature adds to the value of the contract in this simple estimate.Case study
Seen in the real world.
Cobalt Ridge Mining is an illustrative, fictional miner that wants to hedge the price of a metal it will sell in nine months. Its bank offers a knock-out put option, and a version that pays a rebate of $150,000 if the option is cancelled.
The version with the rebate costs $210,000 against $175,000 for the plain structure. The finance director estimates a 20% chance of cancellation, so the expected value of the rebate is 0.20 x 150,000 = $30,000, which she judges to be worth about the $35,000 extra premium.
She decides the rebate is roughly fairly priced but not essential, and chooses the cheaper version. In this illustrative case, she records the reasoning so the board can see the choice was deliberate. She also notes that the 20% chance of cancellation is an estimate, and that a different view of the chance would change the answer.
Watch out
Common mistakes.
- Assuming the phrase has one fixed meaning, when different banks and writers use it in different ways.
- Forgetting that a rebate increases the premium, so it is not free protection.
- Ignoring the timing of the rebate, which may be paid on the trigger date or at expiry.
Questions
People also ask.
Is a rebate option the same as a rebate barrier option?
Often yes in practice, but check the contract, because the phrase can also describe other structures.
Who pays the rebate?
The seller of the option pays it to the buyer when the trigger event occurs.
Is the rebate guaranteed?
It is guaranteed only if the trigger occurs and the seller can pay, so counterparty risk still applies.
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