Rainbow Option

A rainbow option is an exotic derivative whose payoff depends on the performance of two or more underlying assets — typically paying based on the best-performing or worst-performing asset in the basket. A best-of rainbow call, for instance, pays the maximum return from a set of three indices like Nifty 50, Sensex, and Bank Nifty. A worst-of rainbow option — which is cheaper — pays based on the weakest performer in the group. Rainbow options are used by institutional investors to gain optimised exposure to multiple markets simultaneously, or by structured product issuers to offer yield-enhanced notes. Correlation between the underlying assets is a critical pricing factor — lower correlation increases the value of best-of options and decreases the value of worst-of options.