A Rainbow Option is a term used to describe a derivative (option) with many underlying assets. Just like a rainbow which has many colors, these options have two or more underlying assets. For the option to pay off all the assets must move in a similar and desired direction.
These are also called as correlation options or basket options. Rainbow options are often used to distribute the risks over various assets having correlated returns. These also provide a better and diverse portfolio for investors while being cost efficient since correlated multi asset options are cheaper and more competitive than individual options.
These options are often difficult to study because of the different moving parts which have different characteristics. It is necessary for assets to move in a similar direction so as to facilitate a feasible exchange between the assets. Otherwise the investment will not pay off. Also proper and correct modelling of assets is necessary in terms of strike price and expiry dates. The investor should be careful in studying the risk associated with currency fluctuations if an asset is denominated in other currency than the option as well as the correlation risks between underlying assets.
For example, ‘A better-of-two-assets option’ is a rainbow option which allows the investors to earn returns associated to a better performing stock out of two different stocks (underlying assets). Or, to give an instance a option which allows the investor to exchange 5 shares of Citigroup with 1 share Barclays Capital will be termed as a rainbow option. Here the investor will gain if share of Citigroup will fall in value relative to shares of Barclays Capital. Here relativity implies that both should move in a similar direction and gain and loss are dependent upon their comparative values.
To numerically evaluate and price rainbow options standard mathematical finance models such as Black-Scholes and Monte Carlo are most popular.