Exotic Option Development
Plain vanilla derivatives include listed futures contracts and commonly used forwards and other OTC derivatives that are traded in fairly liquid markets. Exotic derivatives are customized to fit a specific firm need.
The main purpose for the development of exotic derivatives is to provide a unique hedge for a firm’s underlying assets. Additional reasons include addressing tax and regulatory concerns as well as speculating on the expected future direction of market prices.
Using Packages to Formulate a Zero-Cost Product
Packages are portfolios of European options, forwards, cash, and the underlying asset. Given that packages often consist of a long position and a short position, they can be constructed so that the initial cost to the investor is zero.
Nonstandard Option
Restricting exercise dates and changing strike prices can transform standard options into nonstandard options.
Types Of Exotic Options
A gap option has two strike prices. If the two strike prices differ and the payoff is non-zero, there will be a gap in the payoff graph that is either increased or decreased by the difference between the strike prices.
Forward start options are options that commence in the future.
A compound option is defined as an option on another option.
Chooser options allow the owner to choose whether the option is a call or a put, after option initiation.
Barrier options are options whose payoffs (and existence) depend on whether the underlying’s asset price reaches a certain barrier level over the life of the option.
Binary options either pay nothing (if price is below strike price) or a fixed amount at expiration.
Lookback options depend on the maximum or minimum value of the underlying asset during the life of the option.
Shout options allow the owner to receive either the intrinsic value of the option at the shout date or at expiration, whichever is greater.
Asian options have payoff profiles that depend on the average underlying asset price over the life of the option.
An exchange option is an option to exchange one asset for another.
Basket options allow the owner to buy or sell portfolios of assets. Exotic options that involve several different assets are more generally referred to as rainbow options.
Volatility and Variance Swaps
A volatility swap involves the exchange of volatility based on a notional principal. A variance swap involves exchanging a pre-specified fixed variance rate for a realized variance rate.
Static Option Replication
Exotic options can be hedged in either a dynamic or static context, depending on the characteristics of the option.
