EXOTIC OPTIONS

D a t e d : 3 RD Nov . 2010

Presented By :
Presented To :
 Options

Vanilla Options
 Exotic Options
§ Exotic options are sophisticated financial
instruments that allow traders to get a right
but not the obligations to buy or sell other
securities.
§ They are called exotic because they do not fit
the standardized options that are traded on
organized exchanges like the New york Stock
Exchange (NYSE).
§ Exotic options are usually bought and sold by
sophisticated investors in the over-the-
counter (OTC) market.
 Types of Exotics Options
§ Package § Lookback options
§ Nonstandard § Shout options
American options
§ Asian options
§ Forward start options
§ Options to exchange
§ Compound options
one asset for
§ Chooser options another
§ Barrier options § Options involving
§ Binary options several assets
§ Volatility and Variance
swaps

 PACKAGES
§ A Package is a portfolio consisting of standard
European calls, standard European puts,
forward contracts, cash, and the underlying
asset itself.
§ Different type of packages are:
 Bull Spreads, bear spreads, butterfly spreads,
calendar spreads, straddles, strangles.
 NONSTANDARD AMERICAN
OPTIONS
 The American options that are traded in the
over-the-counter market sometimes have
nonstandard features.
§ Early exercise may be restricted to certain
dates. The instrument is then known as a
Bermudan option
§ Early exercise may be allowed during only
part of the life of the option. For example,
there may be an initial “lock out” period
with no early exercise.
§ The strike price may change during the life
of the option.
§ The warrants issued by corporations on their
own stock often have some or all of these
 Example
 The warrants issued by corporations
on their own stock often have some
or all of these features.
 For example: in a 7-year warrant,
exercise might be possible on
particular dates during years 3 to 7,
with the strike price being $30 during
years 3 and 4, $32 during the next 2
years, and $33 during the final year.
•
 COMPOUND OPTIONS
Ø Compound options are options on options.
Ø Have two strike prices and two exercise dates.
Ø There are four main types of compound options:
§ A call on a call
§ A put on a call
§ A call on a put
§ A put on a put
For Example, a call on a call:

 On the first exercise date, T1, the holder of the compound option is entitled to
pay the first strike price, k1, and receive a call option. The call option gives the
holder the right to buy the underlying asset for the second strike price, k2, on
the second exercise date, T2. The compound will be exercise on the first
exercise date only if the value of the option on that date is greater than the
strike price.
 DIGITAL OPTIONS

Digital Call Digital Put

o ff a t E xp ira tio n Option Payoff at Expiration

Strike Price Strike Price

0
Spot Price at
Spot Price a
 DIGITAL OPTIONS
Cash or nothing call: Q exp(-rT)
N(d2)
Payoff:

= 0 when Asset Price < Strike Price

= Q when Asset Price > Strike Price

Cash or nothing put: Q exp(-rT)

N(-d2)
Payoff: = 0 when Asset Price > Strike

Price
 DIGITAL OPTIONS
Asset or Nothing Call: S’ exp(-qT)
N(d1)
Payoff:

= 0 if Asset Price <X

= Asset Price if Asset Price > X

Asset or Nothing Call: S’ exp(-qT) N(-

d1)
Payoff:

= 0 if Asset Price >X

= Asset Price if Asset Price < X


 BARRIER OPTIONS

us , its value remains zero even if the price of the underlying should
Option with a Knock - Out
PutBarrier
Option with a Knock - Out Bar
io n V a lu e Option Value

Knock - Out Barrier Knock - Out Barrier

Strike Price Price of the Unde

Price of the Und

Strike Price
 BARRIER OPTIONS
 They are less expensive than
regular options


Classified as:
Knock-out

Knock-in
 Knock-out Option
Down and out call
  Down and in call
§ Ceases to exist if § Exists only if asset
the asset price price reaches the
reaches a certain barrier level
barrier level H.
§ Here, barrier level
is below the
initial asset price.
 Knock-out Option
Up and out call
  Up and in call
§ Ceases to exist if § Comes into
the asset price existence only if
reaches a certain barrier level is
barrier level H. reached.
§ Here, barrier level
is higher than the
certain asset
price.
 LOOKBACK OPTIONS
Payoff depend on the maximum or


minimum asset price reached during

the life of the option.
Floating Lookback call

Payoff = Final asset price-minimum

asset price
Floating Lookback put

Payoff = Maximum asset price-final

asset price

 Shout Options
§ A shout option is one in which the long party can
“shout” at the short party one time during the
life of the option, which sets a sort of lower
payoff level.
§ At maturity, the holder receives either the
intrinsic value at the time of the shout, or the
payoff to a usual European call/put (depending
upon the type of option that it is.)
SHOUT OPTIONS
 ASIAN OPTIONS
Average Price = Maximum (Average Spot Price –


Strike Price, or 0).

 HEDGING EXOTIC
OPTIONS
§ In some cases exotic options are
easier to hedge than the
corresponding vanilla options
(e.g., Asian options)
§ In other cases they are more
difficult to hedge (e.g., barrier
options)
 STATIC OPTIONS
REPLICATION
§ This involves approximately
replicating an exotic option with a
portfolio of vanilla options
§ Underlying principle: if we match the
value of an exotic option on some
boundary , we have matched it at
all interior points of the boundary
§ Static options replication can be
contrasted with dynamic options
replication where we have to trade
continuously to match the option