EXOTIC OPTIONS

Presented by:
Kimaya Kale
Jaitashree Hukerikar
Vrushali Utekar

PG -13- 66
PG -13- 77
PG-13-82

MEANING & DEFINITION:

Exotic Options are those options which differ from

common European or American options.

They are non-standardized options with special conditions

added so as to better serve individual investor needs and

hence traded Over-The-Counter (OTC).
Exotic Options are more complex than simple Vanilla

options, that are traded over the stock exchanges.

Exotic options are the second generation of options

trading.

 Exotic options are more commonly traded in the

currency market than in the stock market.

DISTINGUISHING FACTOR:
EXOTIC OPTIONS.

PLAIN VANILLA OPTIONS.

Customised.

Standardized.

OTC traded

Publicly traded.

Multiple Types.

Single Type.

More Expensive.

Cheaper.

No Standard Pricing.

Standardized Pricing Model.

REASONS TO BUY
EXOTICS :
Exotic options offer a tailor-made protection.
Moderate pricing.

- A trader who has a view of declining volatility can

employ a barrier option instead of strategy based on
vanilla options since this solution is less expensive.
Exotic options also offer structured protection when

Vanilla options cant be successfully employed.

PROBLEMS CONCERNING
EXOTICS
Complexity.
Low liquidity on some exotic option markets.
Another disadvantage of exotic options is that underlying market

might become manipulative if large amounts of exotic options are

traded and approach maturity.
In some cases the writer might for instance try to kill the barrier

options on less liquid underlying market if this would protect

him against large loss when option expires in-the-money.

BARRIER OPTION
A type of option whose payoff depends on whether or not the underlying asset has
reached or exceeded a predetermined price. If the asset crosses the barrier, the option
loses all of its value
Two general kinds:
Knock-in options: meaning it has no value until the underlying reaches a certain
price.
Knock-out options: meaning it can expire worthless if the underlying exceeds a
certain price
For example: let's say that you thought that a particular security was going to go up
over the next six months. However, you did not think that the price would exceed $50
per share. You could buy the barrier at $50 and if the price did not exceed that
threshold, you would make money. If the price exceeded $50 per share, you would
make nothing. This makes the barrier option an "all or nothing" type of investment.

BINARY OPTION :
The binary option is called a binary option because there are only two
possible outcomes at the end of the holding period. You either get paid all
of the winnings or you get nothing. Therefore, this is a high risk, high yield
investment as well.
Put in other terms: if your option expires "in the money" then you are
paid a certain amount of cash. If your option expires "out of the money"
then you receive nothing.
For example, a purchase is made of a binary cash-or-nothing call option on
XYZ Corp's stock struck at $100 with a binary payoff of $1000. Then, if at
the future maturity date, the stock is trading at or above $100, $1000 is
received. If its stock is trading below $100, nothing is received.

ASIAN OPTION :
Asian option (also known as average price option) is an option whose
payoff is determined with respect to the (arithmetic or geometric)
average price of the underlying asset over the term of the option.

Arithmetic Asian Call Option Payoff

= max [0, arithmetic average of underlying's price exercise price]
Arithmetic Asian Put Option Payoff
= max [0, exercise price arithmetic average of underlying's price]
For Example:
On 1 January 20Y3, a trader purchased a 90 day arithmetic call option on
AOL. The option has an exercise price of $35 and the payoff is based on
arithmetic average price of the underlying stock determined after the end
of each 30 day period. The stock price of the underlying asset at 30th,
60th and 90th day of the option was $30.65, $36.9 and $38.49.
Arithmetic Asian call option payoff
= max [0, ($30.65+$36.9+$38.49)/3 $35] = $0.35

COMPOUND OPTION :
A compound option is an option on an option. That is, you can buy an option that gives you
the right (but not the obligation) to buy or sell an underlying vanilla option at an agreed
upon price on an agreed date. If on the expiry date of the compound option itself you can
buy or sell the underlying option at a better rate in the market, you will not exercise the
underlying option. You only pay the premium for the underlying option if you exercise it.
A compound option can take four basic forms, each of which you can buy or
sell:
Call on a call
Call on a put
Put on a call
Put on a put
There is only one common business application that compound options are used for - to
hedge
bids for business projects that may or may not be accepted.

COMPOUND OPTION
For example:
A Japanese company has put in a bid to buy a foreign business for $10 million.
The result of the bid will only be known in two month's time; so for the next
two months, the company has exposure to changes in the USD/JPY spot. The
company does not want to buy a vanilla option as the premium is high and the
outcome of the bid uncertain. A good compromise is to buy a compound, as
the premium is significantly lower and it provides the benefit of a guaranteed
price for the option on a date in the future.

INTEREST RATE OPTIONS :

Definition :
An investment tool whose payoff depends on the future level of
interest rates. Interest rate options are both exchange traded and overthe-counter instruments.
Explanation:
An interest rate option is an agreement giving the buyer the right, but
not the obligation, to fix at a point of time in the future, either the rate
of interest on a notional deposit or loan, or the price of an instrument
such as a futures contract or security, where the price is normally
determined by reference to interest rates. The buyer is protected
against an adverse movement in interest rates, while retaining the
ability to benefit from a favorable movement.

Lookback Options :
Options that give the holder the right to buy (or sell) the underlying asset at
it's lowest (or highest) price over a specified period. There are two different
types of lookback options that vary in how their strike price is set.

A "fixed" lookback option has a strike price that is on the purchase date.
The holder can then exercise the option at maturity using the optimal price
of the underlying asset over the lifetime of the option. For instance, in the
case of a fixed lookback call option the holder would choose the highest
price of the underlying asset over the option lifetime and exercise the option
at the fixed strike price.

A "floating" lookback option is similar, however the option's strike price

is determined at maturity and is set to the lowest (in the case of a call) price
of the underlying asset over the option lifetime.

TARGET MARKET
Lookback Options are applicable for risk averse investors unsure about timing
of the move in the underlying. They are lower risk as there is a high
probability of return. However, they do involve a larger upfront premium.
ADVANTAGES
The buyer will always be able to lock in the most favorable profit that
appeared during the life of the option
DISADVANTAGES
The Lookback Option will require higher premiums than conventional options

Mountain Range Options :

Background
Originally marketed by Socit Gnrale in 1998.
- Traded over-the-counter (OTC), typically by private banks and
institutional investors such as hedge funds.
- These options have combined characteristics of Range and Basket options.
- The options are active for a specified time (characteristic of Range
options) and the payoff is dependant on the performances of multiple
underlying assets (characteristic of Basket options)
- The five most commonly traded Mountain range options are Altiplano,
Annapurna, Atlas, Everest and Himalayan. (names of mountain ranges! )

Altiplano
- The buyer receives a large coupon at maturity if the low barrier is not hit
for any of the underlying basket securities.
- If the barrier is hit, the buyer receives the payoff of a plain vanilla or
sometimes an Asian call on the basket.
- The buyer in these exotic options will aim to let the option ride out by
choosing underlying stocks that will consistently rise.

Annapurna
- Gives the option holder a payoff if none of the stocks from the underlying
basket of securities fall below a predetermined fraction of the initial value
till maturity.
- The buyer has a bullish view on the underlying stocks.
- The more correlated the stocks in the underlying basket are, the higher the
product price will be keeping all other trade parameters constant.

Atlas
- A option here the some of the best and worst performing securities are

removed from the basket of underlies on an observation date on or before the

maturity.
- The payoff similar to a call option on the remaining securities basket at

maturity.
- This product is somewhat similar in characteristics to an Asian call options.

With outliers being removed from the basket the payoff becomes even lesser
volatile. The product should be cheaper to an Asian option with similar trade
parameters.

Everest
-A long term option (10-15 years) with an underlying basket containing
large number of stocks (10-25 stocks).Buyer receives a payoff on the worst
performing member of a large basket of stocks at maturity.

Himalayan
- Like an Asian option, the Himalaya is a call on the average performance of

the best performing stocks within the basket.

- On each observation date, the return level of the best performing stock is

locked in. The stock is then removed from the basket.

- On maturity when only one stock remains, the return level of the remaining

security is locked in for payoff calculation.

- The option's total payout is the sum of all the interim locked in return levels.

Rainbow options
A rainbow option is a derivative whose value is dependent on two or more

underlying securities or events. An example of a rainbow option would be

an outperformance option which allows an investor to exchange one stock
for another. In this case, the investor's decision to exercise the option is
dependent on the price of both stocks.
For example: An option which allows a person to exchange 10 shares

of Morgan Stanley for 1 share of Goldman Sachs would be a rainbow

option. The option holder would gain if Morgan Stanley shares fall in
value relative to Goldman shares, and lose if they relatively increase.
Rainbow options are useful for hedging risks arising from several events.

The price of the rainbow option, to a large extent, is dependent on the

correlation of the underlying events or assets -- with lower correlation
leading to higher prices.

Swaption :
Definition of ' (Swap Option)'
The option to enter into an interest rate swap. In exchange for an option
premium, the buyer gains the right but not the obligation to enter into a
specified swap agreement with the issuer on a specified future date.
The agreement will specify whether the buyer of the swaption will be a fixedrate receiver (like a call option on a bond) or a fixed-rate payer (like a put
option on a bond).

 OTC option for the buyer to enter into a swap at a future date and a

predetermined swap rate

A payer swaption gives the buyer the right to enter into a swap where
they pay the fixed leg and receive the floating leg (long IRS).
A receiver swaption gives the buyer the right to enter into a swap
where they will receive the fixed leg, and pay the floating leg (short
IRS).

Types of Swaptions
For valuation purposes, we also need to distinguish between the two
broad types of interest rate swaptions. An option that gives the right to
pay fixed and receive floating is called a payer swaption, while those
that give the right to receive fixed and pay floating are described as
receiver swaptions. In general option pricing terms, the former
swaption type can be thought of as a call option, and the receiver
swaption treated as a put option.

 European Swaption - a swaption where the holder has the right to enter

into a swap as of a single fixed date.

Bermudan Swaption - a swaption where the holder has the right to enter

into a swap determined by a set schedule of defined exercise dates.

Cancellable swap - a swap with an embedded Bermudan swaption where

the holder can cancel the swap on a one of the set exercise dates.

CONCLUSION :
Earlier exotic options were traded only on OTC but

now they are slowly moving out of the OTC market

and into public exchanges as they gain in popularity.
Since 2008 Binary options has been approved for

listing in the US market for several stocks and indices.

As exotic options continue to gain popularity in the

options trading world, it is expected that more exotic

options will be standardized for trding in the public
exchanges.

THANK
YOU!