3.3.5 Exotic Options

5. Exotic Options

Definition of Exotic Options:
Plain vanilla options: standara European and Amercian options on exchanges.

Exotic options: options with non-standard properties which are designed bu derivatives dealers to meet the specific needs of their clients and are ususlly traded in the OTC markets.

Transformation of American Options:
Standard Amercian option has a fixed exercise price and can be exercised at any time during option’s life.

Nonstandard options make exceptions:

• Early exercise may be restricted to certain dates: Bermuda option
• Early exercise may be allowed during only part of the life of the option-lockout period: Employee stock option.
• Strike price may change during the life of an option: the warrants issued by corporations.

5.1 Single Asset Exotics

5.1.1 Package

A package is a portfolio consisting of plain vanilla options on an asset, such as bull spreads, bear spreads, butterfly spreads, calendar spreads, straddles, and strangles. Packages are sometimes regarded as exotic options because they are positions built to reflect a specific market view and risk tolerance.

For example, an investor who takes a long position in a butterfly spread is acting on his or her belief that the future asset price will be near the middle strike price. At the same time, the investor is building this position without taking on a great deal of risk. In contrast, an investor with a similar view of the market who chooses to sell a straddle or a strangle is taking on much more risk.

5.1.2 Zero-Cost Products

Any derivative product can be converted into a zero-cost product by arranging for it to be paid for in arrears.

Example: A derivative that matures at time T and has a premium equal to $f$. The derivative can be structured for the buyer to pay $f(1+R{)}^T$ at maturity, rather than requiring that the premium be paid upfront.

This is known as a futures-style option.

5.1.3 Forward Start Options

A forward start option is an option that will begin at a future time. It is essentially a forward on an option.

It is usually stated that the option will be at-the-money at the time it starts.

Employee stock options can be forward start options if an employer promises that they will be granted on future dates.

5.1.4 Cliquet Options

A Cliquet option is a series of forward start options with certain rules for determining the strike prices.

Example: Five one-year call options with starting now, in one-year, in two-years, in three-years and in four-years, respectively.

A simple rule for the strike prices could be that each option is initially at-the-money.

5.1.5 Chooser Options

Long position of chooser options has the right to choose whether the option is a call or put. The value of the chooser option at this point is $\text{Max}(c,p)$.

5.1.6 Asian Options

Asian options provide a payoff dependent on an arithmetic average of the underlying asset price during the life of the option.

Asian option is less expensive than a regular option.

• Average price calls: payoff $=\text{Max}(S_{\text{ave}}-X,0)$
• Average price puts: payoff $=\text{Max}(X-S_{\text{ave}},0)$
• Average strike calls: payoff $=\text{Max}(S_T-S_{\text{ave}},0)$
• Average strike puts: payoff $=\text{Max}(S_{\text{ave}}-S_T,0)$

5.1.7 Lookback Options

Lookback options provide a payoff depends on the maximum or minimum asset price reached during the life of the option.

Lookback options are more expensive than regular options.

The value of a lookback option depends on how often the price of the underlying asset is observed. A lookback option increases in value as the observation frequency is increased.

• Fixed lookback calls: payoff $=\text{Max}(S_{\text{max}}-X,0)$
• Fixed lookback puts: payoff $=\text{Max}(X-S_{\text{min}},0)$
• Floating lookback calls: payoff $=\text{Max}(S_T-S_{\text{min}},0)$
• Floating lookback puts: payoff $=\text{Max}(S_{\text{max}}-S_T,0)$

5.1.8 Compound Options

Compound options means options of options, the first option has underlying asset of the second option, and the second option has underlying of other asset. Usually it has 2 layers. It takes similar logic as the FOF or MOM.

The advantages of compound options are that they allow for large leverage.

• Call on call: investor has the right to buy the underlying call option on the expiration date.
• Call on put: investor has the right to buy the underlying put option on the expiration date.
• Put on call: investor has the right to sell the underlying call option on the expiration date.
• Put on put: investor has the right to sell the underlying put option on the expiration date.

5.1.9 Gap Options

Gap option is a European call or put option where the price triggering a payoff is different from the price used in calculating the payoff.

Suppose the trigger price is $X_2$ and the price used in calculating the payoff is $X_1$. This means

• The payoff from a call option is $S_T-X_1$, if $S_T\ge X_2$
• The payoff from a put option is $X_1-S_T$, if $S_T\le X_2$

The payoff from a gap call can be positive, if $X_1<X_2$.
The payoff from a gap call can be negative, if $X_1>X_2$.

The payoff from a gap put can be negative, if $X_1<X_2$.
The payoff from a gap put can be positive, if $X_1>X_2$.

5.1.10 Binary Options

Binary option is a type of option where the payoff is either some fixed amount of some asset or nothing at all.

Two main types of binary option are cash-or-nothing options and asset-or-nothing option.

The cash-or-nothing option pays some fixed amount of cash if the option expires in-the-money.

The asset-or-nothing option pays the value of the underlying security.

Traditional European options can be thought of as combinations of binary options.

A regular European call option is equivalent to

• A long position in an asset-or-nothing call
• A short position in a cash-or-nothing call where the cash payoff in the cash-or-nothing call equals the strike price.

A regular European put option is equivalent to

• A long position in a cash-or-nothing put
• A short position in an asset-or-nothing put where the cash payoff in the cash-or-nothing call equals the strike price.

5.1.11 Barrier Options

Payoffs and existence depend on whether the underlying’s asset price reaches a certain barrier level over the life of the option.

Options that cease to exist when a barrier is reached are knock-out options, and options that come into existence when a barrier is reached are knock-in options.

In-out parity is the barrier option’s answer to put-call parity. If we combine one “in” option and one “out” barrier option with the same strikes and expirations, we get the price of a vanilla option. Note that this arugment only works for Europrean options.

Unlike other simpler options, barrier options are path-dependent. That is , the value of the option at any time depends not just on the underlying at that option, but also on the path taken by the underlying.

• Down-and-out: European option that eases to exist if the asset price moves down to the barrier level.
• Down-and-in: European option that comes into existence if the asset price moves down to the barrier level.
• Up-and-out: European option that ceases to exist if the asset price moves up to the barrier level.
• Up-and-in: European option that come to existence if the asset price moves up to the barrier level.

Barrier options are less expensive than regular options.

• For knock-out options, an increase in the volatility may lower the price.
• For knock-in options, an decrease in the volatility may lower the price.

5.2 Other Types of Exotics

5.2.1 Asset-Exchange Options

In an asset-exchange option, the holder has the right to exchange one asset for another.

An option to exchange X euros for Y Australian dollars.

An offer by Company X to acquire Company Y through the exchange of a certain number of its own shares for shares of Company Y.

5.2.2 Basket Options

A basket option is an option on a portfolio of assets.

Basket options can be appropriate hedging instruments for firms seeking to reduce costs by hedging their aggregate exposure to several assets with a single trade.

Basket options are dependent on the correlation between the returns from the assets in the basket.

It has three specifications of higher leverage, lower tax burden, and flexibility.

5.2.3 Volatility&Variance Swap

A volatility swap is a forward contract on the realized volatility of an asset during a certain period. A trader agrees to exchange a pre-specified volatility for the realized volatility at the end of the period, with both volatilities being multiplied by a certain amount of principal.

A volatility swap is appropriate for a trader who wants to take a position dependent only on volatility. While plain vanilla options provide an exposure to volatility, they also depend on the price of the underlying asset. A potential advantage of volatility swaps is that their payoffs depend solely on realized volatility.

The payoff from a variance swap is calculated analogously to the payoff from a volatility swap. As a reminder, the variance rate for an asset is the square of its volatility.

5.2.4 Static Option Replication

Two portfolios that are worth the same on some boundary (function of asset price and time) must also be worth the same at all interior points.

Some exotics are easier to hedge (e.g. Asian Exotic), while some are more difficult(e.g. Barrier Exotic).

If the boundary hasn’t been reached, static options replication hedge can be left unchanged.

If the boundary is reached, The hedge portfolio must then be unwound and a new hedge should be created.