What is a rebate in barrier options and how does it affect pricing?

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AcadiFi · Accepted Answer

A rebate is a fixed cash amount paid to the option holder if a knock-out barrier is hit (killing the option), or alternatively paid to a knock-in holder if the barrier is never hit (and the option never activates). It serves as a partial compensation for the knock-out event.

Without a rebate, a knock-out option that dies is worth zero at the knock-out moment — the holder loses the full remaining time value. A rebate of, say, 2 dollars per contract cushions this loss. As expected, adding a rebate raises the premium of a knock-out option and lowers the premium of the opposite knock-in (since knock-in with rebate-on-no-touch transfers value to the no-touch state).

Example: portfolio manager Celestine Araya at Montalvo Wealth Advisors buys a down-and-out put on Kestrel Semiconductor. The structured note pays a 3 dollar rebate if the 90-dollar barrier is breached. This converts the binary outcome (worthless upon knock-out) into a softer payoff. Pricing-wise, the rebate is valued as a digital option that pays 3 dollars at the first-touch time, discounted back.

For CFA purposes, remember that rebates break the simple knock-in plus knock-out equals vanilla parity unless properly accounted for on both sides. Always read structured product term sheets carefully — rebate conventions vary by issuer.

What is a rebate in barrier options and how does it affect pricing?

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