EXOTIC OPTIONS

FORWARD START OPTION

DIGITAL/BINARY OPTION
CHOOSER OPTION
SHOUT OPTION
BARRIER OPTION
ASIAN OPTION
EXOTIC OPTIONS
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Options that are exchange traded are plain vanilla options

with routine features.
The prices of these options are generally available as they
are regularly traded.
There exists large variety of tailor-made over-the-counter
products, normally referred as exotics that do not
conform to the specifications of standard options.

Derivatives and Risk Management Rajiv Srivastava

NEED FOR EXOTICS
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Where standard products traded on the exchanges do not

meet the specific requirements of the user, a
modification in the features of the derivative may be
sought.
Universal motivation that causes the improvisation in the
features of the options is the reduction in cost.
Option buyers are constantly looking for ways and means
of reducing the cost of the options by
sacrificing some of the potential gains, and/or
eliminating the highly improbable scenarios which are included in
the calculation of the option premium.

Derivatives and Risk Management Rajiv Srivastava

OPTIONS FEATURES
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Improvisation in the terms of the options can be done

along various parameters that go to determine the option
premium.
Option value is determined by a) Spot, b) Exercise price,
c) Volatility, d) Time for expiration, and e) Risk free return.
Modifications to the terms of the options can be made by
altering any or more of the following:
Frequency and/or timing of exercise,
Manner and quantum of payoff,
Altering the terms of exercise and the exercise price,
Time period when the option is alive or dead, etc.
Derivatives and Risk Management Rajiv Srivastava
FORWARD START OPTION
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Forward start option is the option where

the right is conferred now but

it commences some time in future.

Employee stock options are like forward start options that

start at some time in future.
Of the 5 determinants of option value a) Spot, S b)
Exercise price, X c) Volatility, d) Time for expiration, T
and e) Risk free return, r , only S, X and T are subject of
negotiation of terms of option.

Derivatives and Risk Management Rajiv Srivastava

FORWARD START OPTION
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If commencement time is t with spot at St the time

remaining for maturity is T t then value of the call
would be denoted as ct(St, X, T t).
This value should be no different than the value of the
call today that matures at T t rather than at T, c0(S0, X, T
t).
From homogeneity we may say that they shall be equal.
Employee stock options are like forward start options that
start at some time in future.

Derivatives and Risk Management Rajiv Srivastava

VALUATION - FORWARD START OPTION
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Forward Start Call Option

t=0 t=t t=T
Time

Spot Price S0 St ST

Call Price c0 ct cT

Call Value c(S0, X, T) c(St, X, T t) Max (0, ST X)

= c(S0, X, T - t)
= e-rt x c(S0, X, T - t)
ct(St, X, T t) = c0(S0, X, T t)
Ft = e-rt x ct(St, X, T t)
= e-rt x c0(S0, X, T t)
Derivatives and Risk Management Rajiv Srivastava
FORWARD START OPTION - EXAMPLE
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A firm making an offer to a senior executive. The part of
remuneration is in the form of stock options. With current stock
price of Rs 100 the executive is offered an option to acquire
stock of the firm at strike price of Rs 110 at the end of 2 years.
To ensure commitment the executive would have to work for at
least 12 months (1 year).
The right is being conferred now but would commence only after
12 months. Forward start period is 1 year and option comes into
force for another year.

Derivatives and Risk Management Rajiv Srivastava

VALUATION - FORWARD START OPTION
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Assuming r = 8% and = 25% the value of the call option without
the condition of working at least for 12 months as per BSM is
c0(S0, X, T) = c0(100, 110, 2) = Rs 16.95
If the option cannot be exercised before 12 months the value of
the option at the end of 12 months would be c1(S1, 110, 1) .
This must be equal to c0(100, 110, 1) using the principle of
homogeneity.
As per BSM the value c0(100, 110, 1) = Rs 9.27.
Therefore the value of forward start option with start period of
12 months and expiry of 12 months thereafter.
e-rt x c0(100, 110, 1) = e-.08 x 1 x 9.27
= 0.9231 x 9.27 = Rs 8.56
Derivatives and Risk Management Rajiv Srivastava
BINARY OR DIGITAL OPTION
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Binary option has two discrete payoffs; Q or nothing for

price above X or below X (Cash or Nothing). Alternatively
it could be Asset or Nothing.
Binary option valuation is often used in deciding the
collective reward of employees.
PAYOFF FOR HOLDER AND WRITER FOR BINARY OPTIONS
Cash or Nothing Asset or Nothing
STATE Call Option
Holder Writer Holder Writer
S>X Q -Q S -S
S<X - - - -
Put Option
S>X - - - -
S<X Q -Q S -S
Derivatives and Risk Management Rajiv Srivastava
VALUATION OF DIGITAL OPTION
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Binary Call Option

Value = e-rt . 1 . N(d2) Value = S0 . N(d1)
Value Value

X Spot X Spot
Cash or Nothing Asset or Nothing

Derivatives and Risk Management Rajiv Srivastava

CHOOSER OPTION
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Chooser option provides flexibility to the holder to

choose between the call or put at maturity of chooser, t.
This is also called as you like it option
Value of chooser at time, t = Max (ct, pt).
Value of chooser = c(S0, X, T) + p(S0, X e-r(T - t), t).
For at-the-money chooser option 3 months to expiry with
spot value of Rs 100 and flexibility to choose after 1
month the value would be:
Value of the chooser =
Value of call c(100,100,3/12) + Value of put, p(100, 100 e -0.08 x 2/12, 1/12)

Derivatives and Risk Management Rajiv Srivastava

SHOUT OPTION
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In Shout option the holder shouts for the exercise at

any time prior to maturity of the option.
Shout option enables the holder to assure a minimum
payoff by permitting to book the intrinsic value at the
time of shout.
At the end of the option period the call holder of the
shout option gets higher of a) the intrinsic value at the
time of shout, and b) payoff at maturity.
If call option holder does not shout till maturity it
becomes a regular European call.

Derivatives and Risk Management Rajiv Srivastava

BARRIER OPTIONS
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Barrier options are amongst the most popular as they

reduce the cost of hedging.
They cost less than the regular option because they can
remain alive only for the part of the option period
depending upon the path of the final value.
Knock - in option:
Becomes alive upon touching the barrier price
Knock - out option:
Becomes dead upon touching the barrier price
Knock-in option + Knock-out option = European option
Derivatives and Risk Management Rajiv Srivastava
BARRIER OPTIONS - TYPES
Barrier Options Call ; Assumed Spot = Rs 100 15
KNOCK - IN OPTIONS
TYPE Exercise Barrier Description Features
Price, X Price, B
Option comes to life only Call option suddenly gains intrinsic
when S goes above the worth of Rs 10 the moment it
Up and In 110 120
barrier of Rs 120; else option comes to life.
remains is worthless.
A call option gets activated only
Option comes to life only when spot falls to the barrier of Rs
Down and
110 90 when S goes below Rs 90; 90. Thereafter it behaves like
In
else option is worthless regular option.
KNOCK - OUT OPTIONS
Option is valuable till the S The call option gaining in value
Up and does not touch Rs 120. It with rise in price suddenly loses
110 120 the entire intrinsic worth of Rs 10
Out expires when S goes above
Rs 120. upon touching the barrier.
Call option becomes out-of-
money prior to spot touching the
Down and If S goes below Rs 90 the barrier. The value consists only of
110 90
Out option becomes worthless. time value. Time value becomes
zero upon touching of barrier.

Derivatives and Risk Management Rajiv Srivastava

 BINOMIAL VALUATION
Barrier Options
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Binary Tree for Barrier Option Pricing - Value of Down and out call on underlying asset with 10%
movement, Exercise price = Rs 85, Barrier = Rs 90. Risk free rate = 3% per period
0 4m 8m 12 m Call payoff
0.65 133.10 48.10
121.00
0.65 0.35
110.00 108.90 23.90
0.65 0.35 0.65
100.00 99.00
0.35 0.65 0.35
Barrier = Rs 90 90.00 0.65 89.10 4.10
0.35
81.00
0.35
72.90 -

Derivatives and Risk Management Rajiv Srivastava

BINOMIAL VALUATION
Barrier Options
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Binomial Valuation of Barrier Option

Strike = 85 Barrier = 90 Nature = Down-and-out
Call Payoff Path Call value at T = 12 m
(Rs) Probabilities Standard Barrier
4 8 12 Rs
48.10 u u u 0.65 0.65 0.65 13.21 13.21
u d u 0.65 0.35 0.65
23.90 u u d 0.65 0.65 0.35 10.61 7.07
d u u 0.35 0.65 0.65
u d d 0.65 0.35 0.35
4.10 d u d 0.35 0.65 0.35 0.98 -
d d u 0.35 0.35 0.65
0.00 d d d 0.35 0.35 0.35 - -
Call value at T = 12 m 24.80 20.28
Call value at T = 0 (discounted at 3% per period) 22.69 18.56
Saving with barrier option 19.2%
Derivatives and Risk Management Rajiv Srivastava
ASIAN OPTIONS
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Asian options have payoff that is linked not to the price of

the underlying asset at maturity, but is determined by the
average price during the period
Also called Average options. Like barrier they too are path
dependent as value depends upon the path the price
underlying asset takes during the option period
PAYOFF Average Average Strike
For Call Max (0, Sa X) Max (0, ST - Sa)
For Put Max (0, X Sa) Max (0, Sa - ST)
where Sa is the average of the spot price during the option period
ST is the spot price at maturity

Derivatives and Risk Management Rajiv Srivastava

ASIAN OPTIONS - FEATURES
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Asian options provide hedging based on average rather

than end values. They are popular because
1. of the convention of judging the performance for a given period
over average price during the period,
2. averages are more difficult to manipulate than the prices at single
point of time,
3. averages represent fairer view of trends and prices than the end-
of-the-period prices,
4. they are cheaper than the plain vanilla options.
Asian options are common in foreign currency where the
users are interested in average exchange rate during the
period rather than single end value.
Derivatives and Risk Management Rajiv Srivastava
COMPLEXITY - VALUING AVERAGE OPTIONS
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Valuation of Asian options presents problems due to the

fact that while distribution of stock prices is known to be
log-normal the probability distribution of average is
unknown.
The question of averaging has two dimensions
1. how often the price sample be taken? The observations can be
daily, weekly, monthly etc. and
2. which average would be considered? The choices are arithmetic
or geometric,
Asian options are cheaper because
1. average includes all values and
2. averages have less volatility that the spot values
Derivatives and Risk Management Rajiv Srivastava
ANALYTICAL SOLUTION AVERAGE OPTIONS
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Most average options are based on arithmetic average.

This poses great problem in valuation because the
probability distribution of arithmetic average is not
known and therefore analytical solution just as Black
Scholes model is not possible.
However it is possible to have analytical solution for Asian
options based on geometric average, as geometric
average has normal distribution
Binomial method can be used though analytical models
are available

Derivatives and Risk Management Rajiv Srivastava

VALUING REGULAR AND ASIAN CALL
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Assume S = 100, X = 100, r = 2% per period and up and down

movement by 10% each
Probability of up movement
= (1.02 0.9)/(1.1 0.9) = 0.6
For 3-stage binomial tree the value of regular call option at
maturity would be
= 33.10 x 0.216 + 8.90 x 0.432 + 0 x 0.288 + 0 x 0.064
= 7.1496 + 3.8448 = Rs 10.9944
Therefore present value of the call
= 10.99/1.023 = Rs 10.36
Value of the Asian call with same parameters would be much
lower than the regular call
Derivatives and Risk Management Rajiv Srivastava
BINOMIAL VALUATION
ASIAN CALL OPTION
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Binomial Valuation of Asian Call

Asian call
Binomial Tree Nodes End Path Prob Average Payoff Exp
value X = 100 payoff
133.10 uuu 0.216 121.3667 21.3667 4.6152

121.00
uud 0.144 113.3000 13.3000 1.9152
110.00 108.90 udu 0.144 105.9667 5.9667 0.8592
duu 0.144 99.3000 - -
100.00 99.00
udd 0.096 99.3667 - -
90.00 89.10 dud 0.096 92.7000 - -
ddu 0.096 86.7000 - -
81.00

72.90 ddd 0.064 81.3000 - -

Value of the call at end 7.3896
Value of the call today at r = 2% per period 6.9634

Derivatives and Risk Management Rajiv Srivastava

THANK YOU
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