Question: The following questions deal with range binaries. These are another example of exotic options. Read the following carefully and then answer the questions at the end. Investors are looking to purchase range options. The product is like a straightforward range binary in that the holder pays an upfront premium to receive a fixed pay-off as long as spot maintains a certain range. In contrast to the regular range binary, however, the barriers only come into existence after a set period of time. That is, if spot breaches the range before the barriers become active, the structure is not terminated. This way, the buyer will have a short Vega position on high implied volatility levels. (Based on an article in Derivatives Week (now part of GlobalCapital).)
a. Display the payoff diagram of a range-binary option.
b. Why would FX markets find this option especially useful?
c. When do you think these options will be more useful?
d. What are the risks of a short position in range binaries?