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Master Class: Derivative products: Exotic Options

Exotic Options

Exotic Options can be path dependent or correlation based. Path-dependent options are dependent on the route prices of the underlying asset take through the life of the option (not just the terminal price or rate at maturity).

Bermuda option

This is a blend between an American and European option where the right to exercise the option early is restricted to certain predetermined dates.

Quanto option

Payoff is in a currency other than the currency of the underlying asset (or basket of assets) at predetermined fixed exchange rate. The purpose is to hedge exposure to the asset without being exposed to the currency risk associated with it.

Composite option

This option gives the contract buyer the right to participate in the upside/ downside of both the foreign asset and the related currency that the asset is denominated in. It is a combination of two options:

  • A call (or put) on the underlying asset
  • A call option on the currency of the underlying asset

The payoff is dependent on changes in FX and changes in the price of the underlying foreign currency.

Digital or Binary or “All or nothing” options

There are two main types:

  • Cash or nothing option

    If underlying asset price exceeds the exercise price, the holder will receive a fixed amount from the contract seller. Other wise he will receive nothing.

  • Asset or nothing option

    If underlying asset price exceeds the exercise price, the contract holder will receive the asset from the writer. Otherwise he will receive nothing. Unlike a regular call option, the contract holding does not have to pay the “strike” price.

Barrier options

Payoff depends on whether the underlying asset’s prices crosses some predetermined barrier during a certain period of time. There are a number of types of barrier options including:

  • Knock out options that “die” when the underlying asset’s price crosses the barrier.
  • Knock in options that come into existence when the asset’s price crosses the barrier

Asian options

Payoff depends on the average of the asset prices.

Average Strike Options

Unlike Asian options, instead of using the average of asset prices as the final stock price, this average is used as the strike price when the option is exercised.

Look back options

These are path dependent options whose payouts are dependent on the minimum or maximum price experienced by the underlying asset during the life of the option. Usually these are European options as it is beneficial to the buyer to weight until the maturity of the contract before he exercises his right.

  • For floating look back call, the strike price is the minimum price of the underlying asset in the life of option
  • For floating look back put, the strike price is the maximum price of the underlying asset in the life of option
  • For fixed look back call, the final asset price is replaced with the maximum price of the underlying asset in the life of option
  • For fixed look back put, final asset price is replaced with the minimum price of the underlying asset in the life of option

Look-backs are used in environments of high volatility.

Compound options

This option gives the contract holder the right to buy (or sell) an option, such as a call on call, put on call, call on put, put on put. There are therefore two strike prices at two exercise dates. The call on call contract holder may exercise the option on the first exercise date at the first strike price and receive the call option. Then, the contract holder may exercise his right on the second exercise date at the second strike price to receive the underlying asset.

Chooser (As you like it) options

This option commences at time 0 and matures at T2. At an intermediary time, T1 (0 < T1 < T2) the contract buyer is able to choose whether to treat the option as a put option or call option.

Exchange options

This option allows the holder to exchange one asset (A) for another asset (B). The payoff is max[0, AT– BT].

Forward start options

The option does not commence immediately but at a future point in time, T1. The strike price is usually set equal to the asset price at T1. There most common application is in employee stock option plans.

Basket options

This is an option to buy or sell a portfolio of assets.

Shout options

The payoff under this European option is the maximum of the payoff at the expiration of the contract or the payoff based on the intrinsic value of the option at the time of a “shout” which is one opportunity that the contract holder has to indicate a favorable price movement of the underlying asset to the writer during the life of the contract.

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