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  • 1. Exotic Options- Introduction There are 2 broad categories of stock options in option trading; Standardized Options and Non-Standardized Options. Standardized Options, or sometimes known as quot;Plain- Vanillaquot; Options, are the typical call options and put options traded over the stock exchanges. Standardized Options are the most commonly traded form of options and is what everyone is referring to when talking about call options and put options in options trading. Non-Standardized Options are options that comes with special conditions, making them more flexible and better suited for individual investor needs. As the additional conditions in Non-Standardized Options can be highly complex, they are not normally traded over the stock exchanges for the purpose of option trading. There are, however, a class of non-standardized options which are really standardized in their own types and could therefore be traded between traders who needs those specific conditions. This kind of non-standardized options are known as Exotic Options. Exotic options are more commonly traded in the currencymarket than in the stock market. Features of Exotic Options • Complex Type of Derivatives • Different from Plain Vanilla Options • Traded on OTC • Non-Standardized • Flexible to Cater Individual Needs • Generally Forex Options • Valuation is Difficult Types Of Exotic Options FW2007-09/ F-12/ MFS / Exotic Options 1
  • 2. There are many types of exotic options but the under given are the most commonly traded on OTCs. 1. Basket Options 2. Bermuda options 3. Binary Options 4. Barrier Options 5. Look Back Options 6. Compound Options 7. Asian Options 8. Chooser Options 1. Basket Options Basket options give the holder the right to receive 2 or more foreign currencies for a base currency for a designated or spot rate. They are based on not one underlying asset but a group of underlying assets. The basket can be any weighted sum of underlier values so that the weights are all positives . They are usually cash settled. A call option on France’s CAC 40 stock index is an example of a basket option. Basket options are often priced by treating the basket’s value as a single underlier and applying standard option pricing formulas. 2. Bermuda Options Bermuda options are a hybrid between American and European options. Unlike American options (which can be exercised at any time during a specified period) and European options (which can be exercised only at maturity), Bermuda options may be exercised prior to maturity,but only on certain dates. The most common application of these options is to hedge the embedded call options found in bonds. Since callable bonds can normally only be called on certain days, investors who own them don't need to hedge the call risk every single day – only those specific call dates. For instance, a Bermuda option may allow exercise only on the 1st day of each month before expiration, or on expiration. 3. Binary Options or Digital Options FW2007-09/ F-12/ MFS / Exotic Options 2
  • 3. Binary options (also known as digitals) have a fixed payoff if the option ends up being in the money at expiration, regardless of the extent to which it is in the money. For example, let's assume a binary option is written that pays $1,000,000 if the price of ABC, Inc.'s, stock is above $75 per share at the end of one year. It doesn't matter if the stock is at 75.125 or $220 when the option expires, the payoff will still be $1,000,000. The binary option's value is computed as the payoff multiplied by the probability that the option will be in the money at expiration, discounted back to today. Binary options have several business applications. Perhaps a company has an executive bonus program that awards its senior management $5,000,000 if its stock rises by fifty percent over the next two years. The company could hedge the cost of the compensation program by purchasing a binary option with a $5,000,000 payoff. For this option, the payoff will either be $5,000,000 if the option ends up in the money or nothing if it doesn't. 4. Barrier Options Barrier options are options that are either activated or deactivated when the price of the underlying security passes through some predefined value (the barrier). Barrier options have eight different varieties:  Up and in call – a call option that's activated if the price of the underlying rises above a certain price level.  Up and out call – a call option that's deactivated if the price of the underlying rises above a certain price level.  Down and in call – a call option that's activated if the price of the underlying falls below a certain price level.  Down and out call – a call option that's deactivated if the price of the underlying falls below a certain price level.  Up and in put – a put option that's activated if the price of the underlying rises above a certain price level.  Up and out put – a put option that's deactivated if the price of the underlying rises above a certain price level.  Down and in put – a put option that's activated if the price of the underlying falls below a certain price level.   Down and out put – a put option that's deactivated if the price of the underlying falls below a certain price level. The value of these options is dependent not only upon the value of the underlying security at option expiration, but also the path that the underlying takes prior to expiration. They're therefore known as path-dependent options. FW2007-09/ F-12/ MFS / Exotic Options 3
  • 4. Example A person takes a call option of Rs.100 if the price of the underlying reaches Rs. 107 the payoff will be Rs. 7 but if there is an extra condition that contract expires if prices reaches below Rs. 95 and during the lifetime of contract it reaches to Rs. 94 and at expiration reaches to Rs 107, the payoff will be nil since the contract has expired when it went below Rs. 95 , this is known as knock out barrier option. 5. Lookback Options An exotic option that allows investors to quot;look backquot; at the underlying prices occurring over the life of the option, and then exercise based on the underlying asset's optimal value. This type of option reduces uncertainties associated with the timing of market entry. There are two types of lookback options: 1. Fixed - The option's strike price is fixed at purchase. However, the option is not exercised at the market price: in the case of a call, the option holder can look back over the life of the option and choose to exercise at the point when the underlying asset was priced at its highest over the life of the option. In the case of a FW2007-09/ F-12/ MFS / Exotic Options 4
  • 5. put, the option can be exercised at the asset's lowest price. The option settles at the selected past market price and against the fixed strike. Fixed Strike LookBack Call Options Example: John buys Fixed Strike LookBack Call Options with a strike price of $100 when the underlying asset is trading at $100. The underlying asset falls to $70 immediately before rallying to $120 in a few days. John decides to hold on to see if the underlying asset would rally further. He was wrong and the underlying asset ditches to $80 upon expiration of the Fixed Strike LookBack Call Options. Instead of regretting his decision to hold on, John simply exercise the Fixed Strike LookBack Call Options at the peak price of $120 and pockets the difference of $20 as profit. 2. Floating - A floating strike lookback option can have cash or physical settled. It settles based upon a strike that is set equal to the optimal value achieved by the underlier over the life of the option. In the case of a call, that optimal value is the lowest value achieved by the underlier, so the call has a payoff equal to the difference between the value of the underlier at expiration and the lowest value achieved by the underlier over the life of the option. In the case of a put, the payoff is the difference between the highest value achieved by the underlier and the value of the underlier at expiration. Floating Strike LookBack Put Options Example: John buys Floating Strike LookBack Put Options when the underlying asset is trading at $100. The underlying asset rises to $120 immediately before dropping to $80 in a few days. John decides to hold on to see if the underlying asset would drop further. He was wrong and the underlying asset rallies to $150 upon expiration of the Fixed Strike LookBack Put Options. John exercises the Floatin Strike LookBack Put Options as if g they were bought at a strike price of $150 and exercised at the lowest price of $80, making the difference of $70 in profit. LookBack Options – Pricing Even though a standardized pricing of LookBack Options are not yet agreed upon, it is generally understood that the more volatile the underlying asset, the more expensive LookBack Options will be. Floating Strike LookBack Options would also be generally more expensive than Fixed Strike LookBack Options due to the higher profit potential. Any LookBack Options would also be about twice as expensive as plain vanilla options due to the advantages they confer. Advantages of LookBack Options: 1. Completely eliminates market entry and exit timing problems. 2. Completely maximizes profits within the life of the options. Disadvantages of LookBack Options: 1. Expensive 2. Not publicly traded. 6. Compound Options FW2007-09/ F-12/ MFS / Exotic Options 5
  • 6. A compound option is an option on an option. In the simplest incarnation, compound options take four basic forms: call on a call, call on a put, put on a call, put on a put. They are specified with two strike prices and two expiration dates—one of each for the compound option and one of each for the underlying option. There are two possible option premiums. One is paid up front for the compound option. The other is paid for the underlying option in the event that the compound option is exercised. Generally, the premium for the compound option is modest. However, if the compound option is exercised, the combined premiums will exceed what would have been the premium for purchasing the underlying option outright at the start. Compound option values are extremely sensitive to the volatility of volatility. Application of Compound Option As for Compound Options, Exotic Compound Options are useful in bidding situations, but can reduce the cost of a compound or improve the performance. For example if spot rallies there may be no advantage in having an option to buy a put option - so it might be preferable to have the compound option knockout. Investors can also use compound options to profit from a view of future volatility, by locking in the price of an option in the future. EXAMPLE A major contracting company is tendering for the contract to build two hotels in one month time. If they win this contract they would need financing for DEM223.5mm for 3 years. The calculation used in the tender utilises today's interest rates. The company therefore has exposure to an interest rate rise over the next month. They could buy a 3yr interest rate cap starting in one month but th would prove to be very expensive if they is lost the tender. The alternative is to buy a one month call option on a 3yr interest cap. If they win the tender, they can exercise the option and enter into the interest rate cap at the predetermined premium. If they lose the tender they can let the option lapse. The advantage is that the premium will be significantly lower. ADVANTAGES  Large leverage  Cheaper than straight options DISADVANTAGES  If both options get exercised, the total premium for the compound option wiIl be more expensive than the premium for a single normal option. FW2007-09/ F-12/ MFS / Exotic Options 6
  • 7. 7. Asian Options An option whose payoff depends on the average price of the underlying asset over a certain period of time as opposed to at maturity. Also known as an average option. This type of option contract is attractive because it tends to cost less than regular American options. An Asian option can protect an investor from the volatility risk that comes with the market. There are two basic forms: An average rate option (or average price option) is a cash-settled option whose payoff is based on the difference between a the average value of the underlier during the life of the option and a fixed strike. An average strike option is a cash settled or physically settled option. It is structured like a vanilla option except that its strike is set equal to the average value of the underlier over the life of the option. 8. Chooser Options A chooser option (or preference option) is a path dependent option for which the purchaser pays an up-front premium and has the choice of having the derivative be a vanilla put or call on a given underlier. She has a fixed period of time to make that choice. There is usually a single strike and expiration date that apply to both the put and call alternatives. A typical structure might have the time to choose equal to half the entire time to expiration of the instrument. The chooser feature becomes increasingly valuable with longer choice periods. In the limiting case, as the chooser period approaches the entire time to expiration, the instrument becomes equivalent to a straddle. Not surprisingly, choosers are purchased as inexpensive alternatives to straddles—they are volatility plays. FW2007-09/ F-12/ MFS / Exotic Options 7