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FD/U3 Topic 8 Exotic Option

In finance, an exotic option is an option which has features making it more complex than commonly traded vanilla options. Like the more general exotic derivatives they may have several triggers relating to determination of payoff. An exotic option may also include non-standard underlying instrument, developed for a particular client or for a particular market. Exotic options are more complex than options that trade on an exchange, and are generally traded over the counter (OTC).

Development

Exotic options are often created by financial engineers and rely on complex models to price them.

Features

A straight call or put option, either American or European, would be considered non-exotic or vanilla option. An exotic option could have one or more of the following features:

  • The payoff at maturity depends not just on the value of the underlying instrument at maturity, but at its value at several times during the contract’s life (it could be an Asian option depending on some average, a lookback option depending on the maximum or minimum, a barrier option which ceases to exist if a certain level is reached or not reached by the underlying, a digital option, peroni options, range options, spread options, etc.)
  • It could depend on more than one index such as in basket options, outperformance options, Himalaya options, or other mountain range options
  • The manner of settlement may vary depending on the moneyness of the option at expiry, such as a cash or share option.
  • There could be callability and putability rights.
  • It could involve foreign exchange rates in various ways, such as a quanto or composite option.

Even products traded actively in the market can have the characteristics of exotic options, such as convertible bonds, whose valuation can depend on the price and volatility of the underlying equity, the credit rating, the level and volatility of interest rates, and the correlations between these factors.

Barriers

Barriers in exotic option are determined by the underlying price and ability of the stock to be active or inactive during the trade period, for instance up-and –out option has a high chance of being inactive should the underlying price go beyond the marked barrier. Down-and-in-option is very likely to be active should the underlying prices of the stock go below the marked barrier. Up-and-in option is very likely to be active should the underlying price go beyond the marked barrier. One-touch double barrier binary options are path-dependent options in which the existence and payment of the options depend on the movement of the underlying price through their option life.

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