Aaron
Senior Member
Posts: 6354
Joined: Jul 2001
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Fri Jan 03, 03 04:45 PM
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Baskets are usually, but not always, homogenous assets. They often contain assets denominated in more than one currency, but rarely different asset classes. There's no theoretical reason why not, but there's not much demand for mixed-class baskets.
Baskets are not standardized. A standard basket would be an index.
There is little reason to do spot basket trading. If you want to buy or sell a basket, you can easily buy or sell the underlying components. It only makes a difference for derivatives. For example, a call option on a basket is cheaper than a call option on all the individual components.
It's important to distinguish between true baskets, in which the derivative depends only on the total price of the basket, and multi-underlying derivatives, in which the derivative depends on individual components (for example, a first-to-default basket swap).
The usual reason to do a basket option is one counterparty either owns or is short the basket and wants some kind of protection or exposure. For example, I own a portfolio of 100 bonds. I don't want to buy credit protection on each one, that would wipe out any spread I earn over treasuries. However, I might buy basket protection on the first to default, that will be much cheaper. I will still earn most of my spread, and if only one bond defaults I lose nothing. Or, I might buy protection against more than three bonds defaulting. That gets rid of my catastrophic risk, while still keeping most of my spread.
Or, I might want to buy a put on my stock portfolio that protects me against a loss greater than 20%. Again, buying protection on each stock is too expensive.
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Aaron Brown
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