How does a cliquet option work and what is the ratchet feature?

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AcadiFi · Accepted Answer

A cliquet, or ratchet, option is a series of consecutive forward-start options stacked end-to-end. Each sub-period locks in any gains achieved during that period and resets the strike to the current spot for the next period. Losses are typically floored at zero per period, so the holder keeps every periodic gain. Example: investment advisor Jean-Paul Kowalski at Fjordheim Private Bank sells a five-year annual-reset cliquet note on the Valkoinen 100 index. Each year, the return is calculated as the index performance over that year, floored at zero and capped at 8 percent. The total payoff sums the yearly returns. If annual returns are plus 12, minus 5, plus 7, plus 3, plus 15, the cliquet pays 8 + 0 + 7 + 3 + 8 equals 26 percent, even though the cumulative compound return over the five years might be different. ```mermaid flowchart LR Y1[Yr1 +12%
cap 8%] --> Y2[Yr2 -5%
floor 0] Y2 --> Y3[Yr3 +7%] Y3 --> Y4[Yr4 +3%] Y4 --> Y5[Yr5 +15%
cap 8%] Y5 --> S[Sum = 26%] ``` Cliquets are attractive to conservative investors who want equity upside with principal protection and locked-in gains. They are expensive options for the issuer due to volatility-of-volatility exposure (vol-of-vol), and mispricing during the 2008 crisis caused significant losses at several European banks.

How does a cliquet option work and what is the ratchet feature?

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