In
finance, an exotic option is an
option which has features making it more complex than commonly traded
vanilla option
In finance, an option is a contract which conveys to its owner, the ''holder'', the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified dat ...
s. Like the more general
exotic derivatives
An exotic derivative, in finance, is a derivative which is more complex than commonly traded "vanilla" products. This complexity usually relates to determination of payoff; see option style.
The category may also include derivatives with a non- ...
they may have several triggers relating to determination of payoff. An exotic option may also include a 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
Exchange may refer to:
Physics
*Gas exchange is the movement of oxygen and carbon dioxide molecules from a region of higher concentration to a region of lower concentration. Places United States
* Exchange, Indiana, an unincorporated community
* ...
, and are generally traded
over-the-counter
Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid prescr ...
.
Etymology
The term "exotic option" was popularized by
Mark Rubinstein
Mark Edward Rubinstein (June 8, 1944 – May 9, 2019) was a leading financial economist and financial engineer. He was ''Paul Stephens Professor of Applied Investment Analysis'' at the Haas School of Business of the University of California, Be ...
's 1990 working paper (published 1992, with Eric Reiner) "Exotic Options", with the term based either on
exotic wagers in
horse racing, or due to the use of international terms such as "Asian option", suggesting the "exotic Orient".
Journalist Brian Palmer used the "successful $1 bet on the
superfecta {{Wiktionary
The superfecta is a type of wager in USA and Canada parimutuel betting in which the bettor, in order to win, must pick the first four finishers of a race in the correct sequence. This is even more unlikely than a successful wager in th ...
" in the 2010 Kentucky Derby that "paid a whopping $101,284.60" as an example of the controversial high-risk, high-payout exotic bets that were observed by track-watchers since the 1970s in his article about why we use the term exotic for certain types of financial instrument. Palmer compared these horse racing bets to the controversial emerging exotic financial instruments that concerned then-chairman of the
Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
Paul Volcker
Paul Adolph Volcker Jr. (September 5, 1927 – December 8, 2019) was an American economist who served as the 12th chairman of the Federal Reserve from 1979 to 1987. During his tenure as chairman, Volcker was widely credited with having ended th ...
in 1980. He argued that just as the exotic wagers survived the media controversy so will the exotic options.
In 1987, Bankers Trust Mark Standish and David Spaughton, were in Tokyo on business when "they developed the first commercially used pricing formula for options linked to the average price of crude oil." They called this exotic option the
Asian option An Asian option (or ''average value'' option) is a special type of option contract. For Asian options the payoff is determined by the average underlying price over some pre-set period of time. This is different from the case of the usual European o ...
, because they were in Asia.
Development
Exotic options are often created by
financial engineer
Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of programming. It has also been defined as the application of technical methods, especially from mathema ...
s and rely on complex models to price them.
Features
A straight
call
Call or Calls may refer to:
Arts, entertainment, and media Games
* Call, a type of betting in poker
* Call, in the game of contract bridge, a bid, pass, double, or redouble in the bidding stage
Music and dance
* Call (band), from Lahore, Paki ...
or
put option, either
American
American(s) may refer to:
* American, something of, from, or related to the United States of America, commonly known as the "United States" or "America"
** Americans, citizens and nationals of the United States of America
** American ancestry, pe ...
or European, would be considered a non-exotic or vanilla option. There are two general types of exotic options: path-independent and path-dependent. An option is path-independent if its value depends only on the final price of the underlying instrument. Path-dependent options depend not only on the final price of the underlying instrument, but also on all the prices leading to the final price. 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 Lookback options, in the terminology of finance, are a type of exotic option with path dependency, among many other kind of options. The payoff depends on the optimal (maximum or minimum) underlying asset's price occurring over the life of the opt ...
depending on the maximum or minimum, a
barrier option A barrier option is an option whose payoff is conditional upon the underlying asset's price breaching a barrier level during the option's lifetime.
Types
Barrier options are path-dependent exotics that are similar in some ways to ordinary options. ...
which ceases to exist if a certain level is reached or not reached by the underlying, a
digital option
A binary option is a financial exotic option in which the payoff is either some fixed monetary amount or nothing at all.Breeden, D. T., & Litzenberger, R. H. (1978). "Prices of state-contingent claims implicit in option prices". ''Journal of Busin ...
, peroni options, range options,
spread options, etc.)
* It could depend on more than one index such as in
basket option
A basket option is a financial derivative, more specifically an exotic option, whose underlying is a weighted sum or average of different assets that have been grouped together in a basket. A basket option is similar to an index option, where a nu ...
s, outperformance options, Himalaya options, or other mountain range options
* The manner of settlement may vary depending on the
moneyness
In finance, moneyness is the relative position of the current price (or future price) of an underlying asset (e.g., a stock) with respect to the strike price of a derivative, most commonly a call option or a put option. Moneyness is firstly a thr ...
of the option at expiry, such as a
cash or share option
Cash or Share Option is a specialized form of warrant where the settlement is either cash or physical delivery of shares depending if the option expires in the money or out of the money.
Normally, the holder of the certificate receives the exe ...
.
* There could be callability and putability rights.
* It could involve foreign exchange rates in various ways, such as a
quanto A quanto is a type of derivative in which the underlying is denominated in one currency,
but the instrument itself is settled in another currency at some rate. Such products are attractive for speculators and investors who wish to have exposure to a ...
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
A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.
...
, the level and volatility of
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...
s, 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
price
A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the ...
s 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.
Examples
*
Barrier
A barrier or barricade is a physical structure which blocks or impedes something.
Barrier may also refer to:
Places
* Barrier, Kentucky, a community in the United States
* Barrier, Voerendaal, a place in the municipality of Voerendaal, Netherl ...
*
Cash or Share
*
Cliquet A cliquet option or ratchet option is an exotic option consisting of a series of consecutive forward start options. The first is active immediately. The second becomes active when the first expires, etc. Each option is struck at-the-money when it ...
*
Compound option A compound option or split-fee option is an option on an option. The exercise payoff of a compound option involves the value of another option. A compound option then has two expiration dates and two strike prices. Usually, compounded options are ...
*
Constant proportion portfolio insurance
Constant proportion portfolio investment (CPPI) is a trading strategy that allows an investor to maintain an exposure to the upside potential of a risky asset while
providing a capital guarantee against downside risk. The outcome of the CPPI stra ...
*Digital/
Binary option
A binary option is a financial exotic option in which the payoff is either some fixed monetary amount or nothing at all.Breeden, D. T., & Litzenberger, R. H. (1978). "Prices of state-contingent claims implicit in option prices". ''Journal of Busin ...
*
Lookback
*
Rainbow option Rainbow option is a derivative exposed to two or more sources of uncertainty, as opposed to a simple option that is exposed to one source of uncertainty, such as the price of underlying asset.
The name of ''rainbow'' comes from Rubinstein (1991), ...
*
Timer call
*
Unit Contingent Options
*
Variance swap A variance swap is an over-the-counter financial derivative that allows one to speculate on or hedge risks associated with the magnitude of movement, i.e. volatility, of some underlying product, like an exchange rate, interest rate, or stock index. ...
*
Bermudan options
*
Box option
References
Further reading
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{{Derivatives market
Mathematical finance
Options (finance)