What is a Rainbow Option?

A rainbow option is an option linked to two or more underlying assets.

How Does a Rainbow Option Work?

Just as rainbows have many colors, options can have many underlying assets. A Margrabe option, for example, gives the buyer the right but not the obligation to exchange one asset for another at a set price on or before the expiration date. In order for an option like this to make money for the investor, the price of the first asset and the price of the second asset both have to move in the desired direction to make exchanging one asset for another worthwhile. Because the option has 'more than one color,' we call Margrabe options rainbow options, though any option that derives its value from more than one asset is considered a rainbow option.

Why Does a Rainbow Option Matter?

Rainbow options can be difficult to analyze because of their many moving parts, but the main idea is that all of the underlying assets in a rainbow option have to move in the 'right' direction in order for the investment to pay off.