# Accumulator Option Pricing

Teaching Notes
Author
Affiliation

Macquarie University

Published

May 29, 2019

An accumulator is a financial derivative that is sometimes known as “I kill you later”. This post attempts to explain how it is structured and price it via Monte Carlo simulations in Python.

## 1. Overview of Accumulator

Like all derivatives, there are two parties involved in an accumulator, the buyer and the seller, both agree on a strike price that is usually at a discount to the prevailing market price of the underlying security at the time of contract origination.

• The buyer has the obligation to buy certain amount of the underlying security at the predetermined strike price.
• The seller has the obligation to sell the specified amount of the underlying security at the strike price to the buyer.

The accumulator is settled periodically throughout its term. At each settlement:

• If the market price of the underlying security is above the predetermined knock-out price, the contract is terminated.
• If the market price of the underlying security is between the knock-out price and the strike price, the buyer “accumulates” the underlying security at the strike price.
• If the market price of the underlying security is below the strike price, the buyer is obligated to buy the underlying security at the strike price at 2 (or more) times of the predetermined amount.

## 2. An Example 6-month Accumulator

Let’s make up an example so as to illustrate how it works.

## 3. Some Observations

In the example above:

All these taken together, we can find that the buyer has:

1. a limited upside potential because the potential gain is capped by the knock-out price and zero when knocked out, and
2. a disproportional (limited) downside in that any loss is amplified by the doubled amount of shares he or she has to purchase from the seller when share price is below the strike.

But this is not the full story. Another hidden feature is that while the accumulator is terminated when the share price is above the knock-out price, the contract does not terminate when the buyer is at a loss until it matures. So, even though the maximum losses of both the buyer and the seller are fixed, but they differ significantly and disproportionately.

If so, why would anyone become interested in buying the contract? Potentially it’s because the strike is set to be lower at market price, therefore at the beginning the buyers always feel like they are taking advantages. They may also think that once the price increases to above the knock-out level, which might be set to slightly higher than market price, the contract is terminated so they are free of any loss.

However, the buyers often underestimate the probability of a price decline and how big the impact it will have on accumulator buyers. The “I kill you later” earns its name for a reason.

## 4. Some Math …

Let’s make some notations.

• Strike price is $$K$$
• Share price at time $$t$$ is $$S_t$$
• Knock-out price is $$K^+$$
• The amount of shares to buy is:
• $$A$$ when $$K<S_t<K^+$$, and
• $$cA$$ when $$S_t>K^+$$, where $$c>1$$
• There are $$N$$ settlements

So at each settlement, the payoff matrix conditional on the contract not terminated in the previous settlement is:

Share Price Buyer’s Payoff Seller’s Payoff
$$S_t>K^+$$ 0 0
$$K\le S_t\le K^+$$ $$A(S_t-K)\ge0$$ $$-A(S_t-K)\le0$$
$$S_t<K$$ $$c A(S_t-K)<0$$ $$-cA(S_t-K)>0$$

However, deriving a closed-end analytical solution is not easy since there are many settlements in the contract and the total payoff is path-dependent (the knock out).1

1 There is a conference paper in 2009 discussing the issue and the PDF version is available here.

## 5. … A Simulation Approach

I am to going to use Monte Carlo simulations to find out the distribution of buyer’s payoff.

### 5.1. Assumptions

For simplicity, I’m going to make the following assumptions:

• the share price when the contract is signed $$S_t=100$$.