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FRM Part I · FRM Exam Part I · Exotic Options

A trader holds a down-and-out call option on a stock. The current stock price is 100, the strike is 95, and the barrier is 85. Which statement is correct?

The option is cancelled if the stock ever hits 85 before expiry, even if it later recovers above the strike. A down-and-out option is path dependent: touching the lower barrier extinguishes it permanently, unlike a down-and-in option, which activates at the barrier.

  1. AThe option is cancelled if the stock price ever trades at or below 85 before expiry, even if it later recoversCorrect
  2. BThe option becomes active only if the stock price falls to 85
  3. CThe option is cancelled only if the stock price is below 85 at expiry
  4. DThe option is cancelled if the stock price ever rises above 85

Explanation

A down-and-out option is knocked out when the underlying touches the barrier below the initial price during the life of the option. Once knocked out it is worthless even if the price recovers. Becoming active at the barrier describes a down-and-in option. Observing only at expiry is not the standard path-dependent feature.

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