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Indexed Underlying Price Options

Indexed options - designed primarily for executive compensation - are stock options that turn in the money if the yield of a stock exceeds the yield of a benchmark index. In this article we show that the indexed options analyzed in the literature so far - where the exercise price of the option was indexed - do not exclude all the risks related to the index. Therefore we propose a new type of indexed option - a so called indexed underlying price option - and show that in case of this product all the risks related to the index can be excluded. We determine the explicit formulae for the valuation of these options. Finally, we show that these options can be used as standardized, exchange traded products as well, thus their application can be extended beyond executive compensation.