What it means
A normal option gives the holder the right to buy or sell an asset at a set price. A barrier option adds a trigger level.
A knock-out option dies if the asset price touches the barrier, while a knock-in option only comes alive if it does. The catch with a standard barrier option is that the buyer can lose the whole premium (the price paid for the option) when the barrier is hit.
A rebate barrier option reduces that pain. If a knock-out option is cancelled, the seller pays the buyer a pre-agreed rebate, and for a knock-in option, a rebate is usually paid if the barrier is never reached by expiry.
Barrier options are cheaper than ordinary options because they carry the risk of cancellation. Adding a rebate raises the price somewhat, since the seller has promised a payout in the bad scenario.
The buyer chooses whether the extra cost is worth the comfort. Companies use them for hedging at a lower cost than standard options.
For example, an exporter worried about a falling foreign currency may buy a knock-out put, accepting that the hedge ends if the currency rises past a barrier. The rebate gives some cash back if that happens.
These products are complex and carry counterparty risk, because the seller must be able to pay. The terms need to state clearly how the barrier is monitored, whether continuously or only at set times, and when the rebate is paid.
Finance teams should have specialists price and review them.
In practice
Real-world examples.
Example
An importer hedges its currency exposure with a knock-out option that includes a rebate. If the exchange rate moves past the barrier, the hedge ends but the importer receives a rebate that covers part of the premium. The treasury team has a smaller loss than it would with a plain barrier option.
Example
A fund manager buys a knock-in call on an index that only becomes active if the index touches a higher level. Because he worries it may never be reached, he negotiates a rebate for that case. The rebate makes the structure feel less like a pure gamble.
Example
A commodity processor buys a barrier option to cap the cost of copper at a lower premium than a standard option. The bank explains that the rebate is paid only at expiry. The processor factors this timing into its cash flow forecast.
Formula
Calculation
Payoff of a down-and-out call with rebate = Maximum of (Final price - Strike, 0) if the barrier is never touched; otherwise the rebate
Suppose a company buys 1,000 call options on a share with a strike of $100, a barrier of $85 and a rebate of $3 per share, paying a premium of $4 per share, or $4,000 in all. If the share never touches $85 and finishes at $112, the payoff is (112 - 100) x 1,000 = $12,000, so the net gain is 12,000 - 4,000 = $8,000. If the share touches $85, the option is cancelled and the rebate pays 3 x 1,000 = $3,000, a net loss of 3,000 - 4,000 = -$1,000. Without the rebate, the net loss in that case would have been the full $4,000.Case study
Seen in the real world.
Tidewater Shipping is an illustrative, fictional company that needs to buy 20,000 tonnes of fuel in six months. Its treasurer buys a knock-out call option on fuel with a rebate, because the premium for a plain call option would cost $90,000 and the barrier version costs only $55,000 plus $5,000 for the rebate feature.
If the fuel price rises through the barrier, the option is cancelled and Tidewater receives a rebate of $20,000. The treasurer explains that this leaves the company unhedged exactly when prices are rising, so the rebate is a partial consolation, not protection.
The price stays below the barrier and the option pays out as designed. In this illustrative case, the board approves similar structures in future but sets a policy to review the barrier risk each quarter.
Watch out
Common mistakes.
- Treating the rebate as full protection when it is usually a small fraction of the loss on the option.
- Overlooking when the rebate is paid, since some contracts pay at the barrier event and others only at expiry.
- Ignoring the risk that a hedge disappears just when it is needed most.
Questions
People also ask.
What is the difference between knock-in and knock-out?
A knock-in option becomes active only if the barrier is reached, while a knock-out option ceases to exist if it is reached.
Why add a rebate?
It gives the buyer some money back if the option is cancelled, which reduces the downside at a higher premium.
Are these options traded on exchanges?
Mostly not, as they are customised over-the-counter contracts agreed with a bank.
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