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Exotic Report
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
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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
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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.
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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
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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
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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.
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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.
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