Rainbow option

Rainbow option is a derivative exposed to two or more sources of uncertainty, as opposed to a simple option that is exposed to one source of uncertainty, such as the price of underlying asset.

The name of rainbow comes from Rubinstein (1991), who emphasises that this option was based on a combination of various assets like a rainbow is a combination of various colors. More generally, rainbow options are multiasset options, also referred to as correlation options, or basket options. Rainbow can take various other forms but the combining idea is to have a payoff that is depending on the assets sorted by their performance at maturity. When the rainbow only pays the best (or worst) performing asset of the basket, it is also called best-of (or worst-of). Other popular options that can be reformulated as a rainbow option are spread and exchange options.