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Exotic Options

After completing this reading, you should be able to:

• Define and contrast exotic derivatives and plain vanilla derivatives.
• Describe some of the factors that drive the development of exotic products.
• Explain how any derivative can be converted into a zero-cost product.
• Describe how standard American options can be transformed into nonstandard American options.
• Identify and describe the characteristics and payoff structure of the following exotic options: packages, zero-cost products, nonstandard American options, gap, forward start, compound, chooser, cliquet, barrier, binary, lookback, Asian, asset exchange, and basket options.
• Describe and contrast volatility and variance swaps.
• Explain the basic premise of static option replication and how it can be applied to hedging exotic options.

Exotic Derivatives vs. Plain Vanilla Derivatives

Plain vanilla derivatives represent the most basic version of financial derivatives, including futures contracts, forwards, swaps, and over-the-counter (OTC) instruments used in fairly liquid markets. They have a simple expiration date, exercise price and have no additional features. On the other hand, exotic derivatives alter the traditional characteristics to create a complex financial instrument that’s tailored to meet the specifications of a particular counterparty.

In a plain vanilla derivative, most details are precisely outlined and straightforward. Such details include the initial cost, current market value, expiration date, amounts to be paid, and the cost of the existing position. For exotic derivatives, most of these issues are negotiable.

Some of the reasons behind the development of exotic derivatives include the need to:

• Create a customized hedge that reflects the composition of an entity’s underlying assets
• Address tax and regulatory concerns
• Develop products that reflect the direction of future market prices

Conversion of Derivatives into a Zero-cost Product

When two or more derivatives with contrasting features are combined, a package is formed. Common packages include a bull, bear, calendar spread, or even a straddle, as discussed in the previous chapter. Through these packages, a trader can create a zero-cost product.

Take a collar, for example. The trader combines a long position in a put with a lower strike price and a short position in a call with a higher strike price. If the premium received after selling the call offsets the premium paid for the put, the overall cost of the combined position is reduced to zero.

The option premium for a zero-cost product is not paid up-front. Zero cost products have been customized in such a way that the option premium is payable at maturity as x(1+r)t where x is the premium that would have been paid now, t is the time to maturity, and r is the interest rate. In this arrangement, the future value of the option premium, x(1+r)t, is exchanged for the option payoff at option maturity.

Transforming a Standard American Option into a Nonstandard American Option

One of the most prominent characteristics of standard American options is the possibility to exercise them on or before the expiration date. However, there are certain things that could be done that effectively transform a standard option contract into a non-standard one. These include:

• Restricting early exercise to only a few specified dates

For example, a six-month American call could be exercisable only on the last day of each month. Such a restriction creates what’s called a Bermudan option.

• Imposing a lock-out period during which the option cannot be exercised

For example, a 3-month lockout period could be imposed on a six-month call. That means the holder is not allowed to exercise the option during the first three months of the contract.

Lookback Options

A lookback option allows the holder to exercise an option at the most beneficial price of the underlying asset over the life of the option.

Lookback options have two main categories, that is, floating lookback options and fixed lookback options.

Asian Options

In an Asian option, the payoff depends on the average price of the underlying asset over a period of time as opposed to standard options, where the price of the underlying determines the payoff at a specific point in time.

Exotic Options Involving More than One Asset

Asset Exchange Options

As the name suggests, asset exchange options provide room for investors to be able to exchange their assets for another asset. For example, an investor based in the US may exchange his US dollars for Canadian dollars.

A basket option gives the right but not the obligation to buy or sell a basket of securities. The components of the basket could be bonds, stocks, currencies, e.t.c., and maybe specified in advance.

Options Dependent on Volatility

Volatility and Variance Swaps

In a volatility swap, volatility is exchanged based on a notional principal. Similarly, a variance swap involves the exchange of variance – the square of volatility – based on a notional principal. Volatility and variance swaps do not bet on the price of the underlying.

Variance swaps can be replicated using a collection of puts and calls. They are easier to price compared to volatility swaps.

Hedging Exotic Options

Hedging of exotic options can be done by creating a delta neutral position and rebalancing frequently to maintain delta neutrality. However, some exotic options, such as barrier options, are relatively difficult to hedge. To hedge a barrier option, the portfolio that replicates its boundary conditions must be shorted and unwound when any part of the boundary is reached. The advantage of static options replication is that it does not require frequent rebalancing.

Question

A cash-or-nothing call option has a payout profile equivalent to zero or:

A. The underlying asset price if the value of the asset ends below the strike price.

B. The underlying asset price if the value of the asset ends above the strike price

C. A set amount if the value of the underlying asset ends below the strike price

D. A set amount if the value of the underlying asset ends above the strike price.

A cash-or-nothing call option pays a fixed amount as long as the value of the underlying asset is above the strike price at expiration. It differs from a standard call since the payoff does not increase as the underlying’s market price soars above the strike price.

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