BY CHRIS DIBELLA Exotic Options. Options A financial derivative that represents a contract sold by one party to another. This contract offers the buyer.

BY CHRIS DIBELLA

Exotic Options

Options

A financial derivative that represents a contract sold by one party to another.

This contract offers the buyer the right to buy or sell a security at an agreed upon price during a certain period of time.

Two types: Vanilla and Exotic

Exotic Options

Term was popularized by Mark Rubinstein in 1990 Based on either exotic wagers in horse racing or from

the use of exotic terms when naming options

Options with more complex features than vanilla options

Usually traded over the counter Directly between two parties Option can be tailored to fit any situation

Path Dependence vs. Independence

Dependent Value of the option depends on the path the

underlying takes

Independent Value depends only on the value of the underlying

when exercised or expired

Pricing Methods

Expected payoff pricingBlack-Scholes MethodBinomial TreesMonte Carlo Methods

Generate many random walks

Average option values anddiscount to current prices

dxdtS

ds

Asian Options

Introduced in Tokyo, Japan in 1987

Payoff is determined by the average underlying price over a pre-set period of time

Two Types: Fixed Strike

Payoff is the difference between a set strike price and the average value of the underlying

Floating Strike Payoff is the difference between the underlying value at

expiration and the average underlying value

Examples

Fixed Strike Floating Strike

Why buy an Asian Option

Want to cover many transactions using only one hedging instrument

Reduce the dependence of an option on the spot price of the underlying on a single date

Less expensive since the volatility of the average price is usually less than the volatility of the spot price

Binary Options

aka digital options or all-or-nothing options

Can be calls or puts, American or European

Payoff is either a fixed amount or nothing

Two Types Cash-or-nothing

Pays fixed amount if the underlying is in the money Asset-or nothing

Pays the value of the underlying

Pricing

Cash or Nothing Payoff is a constant

Asset or Nothing Payoff is the value of the underlying, ST

K

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K

rT dsSSpdfe )()(

Barrier Options

Similar to vanilla options – can be calls or puts, American or European

Becomes active or inactive after the underlying crosses a certain point Knock-In Options-Option becomes active only if the

underlying crosses the barrier Knock-Out Options-Option becomes void if the underlying

crosses the barrier

Once the underlying passes the barrier it does not matter if it passes it again

Example

Call Option Comparison

You are looking to buy a call option on a stock with the following information: S0=100, K=100, r=.003, σ=.3, T=1.5

Vanilla Call Value - $14.77

What do you expect the value of the same call with a Knock-Out barrier, B=150, to be?

As the barrier moves closer the strike price, what do you think will happen to the value of the option?

Barrier Price

Knock-Out Barrier

150 140 130 120 110 100

Option Price

3.51 2.04 .91 .25 .02 0

Why buy a Barrier Option?

Cheaper than a plain call or put Creates opportunity for greater profits

Expect movement within a limited range

Disadvantages Knock-Out

Too much movement could void an option Knock-In

Option can be out of the money even when it has passed the strike price

Lookback Options

Created in 1979 by Robert C. MertonCalls or PutsAllows holder to “lookback” for the optimal

valuesTwo Types:

Fixed Strike Payout is difference between strike price and the

maximum or minimum value of the underlying Floating Strike

Payout is difference between underlying value at expiration and the maximum or minimum value of the underlying

Example

Call Option Comparison

You are looking to buy a call option on a stock, with the following information: S0=100, K=100, r=.003, σ=.3, T=1.5

Vanilla Call Value - $14.77Knock-Out Call Value - $3.51

What do you expect the value of the same call with a fixed strike lookback?

Why buy a Lookback Option

Eliminates any timing problems

Maximizes payoff

Disadvantages Expensive

Other Exotic Options

Chooser Option Allows holder to choose whether it is a call or put at a

particular dateRainbow Option

Option linked to two or more underlying valuesShout Options

Option that allows holder to adjust aspects of the option at certain intervals, such as the strike price or time to maturity

Sources

http://www.riskglossary.com/ http://en.wikipedia.org http://www3.sitmo.com

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