EXOTIC OPTIONS
Aaron Bany
May 21, 2013
BA 543-002 Financial Markets and Institutions
What is an option?
A financial derivative that represents a contract sold by one party (writer) to another party (holder)
It offers the holder the right, but not the obligation, to exercise the option to either buy or sell an underlying asset when predetermined conditions are met
How Options Function
Option = f(S, K, T, rf, σ)
S = share price
K = strike price
T = time to maturity
rf = risk free rate
σ = volatility of underlying asset
2 Types of Options Vanilla Options (2 forms)
American Option European Option
Exotic Options (unlimited) Bermuda Options Chooser Options Performance Options Compound Options Binary Options Barrier Options Asian Options Lookback Options Etc.
Exotic Options
The term “exotic” was popularized by Mark Rubinstein in 1990
Used to describe any option that is more complex than a vanilla American or European option
Binary Options
It either pays out or it doesn’t 2 types
Cash-or-Nothing○ Pays the fixed amount if the asset is “in-the-
money”Asset-or-Nothing
○ Pays the value of the underlying
Barrier Options: Knock-In Up-and-in: activated by moving up and beyond the
barrier
Down-and-in: activated by moving down and beyond the barrier
Knock-In Call option – Asset begins the day at $75
Scenario 1Time = 1 dayStrike Price = $80Barrier Price = $90Closing Price = $85Call Payout = $0
Scenario 2Time = 1 dayStrike Price = $80Barrier Price = $90Closing Price = $95Call Payout = $15
Barrier Options: Knock-Out Up-and-out: deactivated by moving up and beyond the
barrier
Down-and-out: deactivated by moving down and beyond the barrier
Knock-Out Call option – Asset begins the day at $75
Scenario 3Time = 1 dayStrike Price = $80Barrier Price = $90Closing Price = $85Call Payout = $5
Scenario 4Time = 1 dayStrike Price = $80Barrier Price = $90Closing Price = $95Call Payout = $0
Barrier Options
Double One-Touch Double No-Touch
One-Touch No-Touch
Why Binary and Barrier Options?
You don’t have to be an expert trader
You know the risk and payoff
Short time to maturity
High payoutROI of 50-70%Linked to the direction the asset trending and
not the difference in price
Asian Options Originated in Tokyo, Japan in 1987
Payoff is based on the average price of the asset over a pre-set period of time
Fixed Strike – payoff is the difference between the strike price and average value
Floating Strike – payoff is the difference between value at expiration and average value
Asian Option ExampleFixed Strike Floating Strike
Average = $102Pre-Set Strike = $80Call Payout = $22Put Payout = $0
Average = $102Strike @ maturity = $110Call Payout = $0Put Payout = $8
Why Asian Options?
Reduce the dependence of the value of the option on the spot price of the asset on a specific date
Less expensive because its volatility is usually less then the underlying assets spot price
Lookback Options Payout depends on the underlying assets
maximum (call) or minimum (put) price over the life of the option
Fixed Strike – payoff is the difference between a pre-set strike and the min or max value
Floating Strike – payoff is the difference between optimal price (the strike) and the min or max value
Lookback Options
Fixed Strike Floating Strike
Pre-Set Strike = $95Highest Price = $130Call Payout = $35Lowest Price = $75 Put Payout = $20
Highest Price = $130Lowest Price = $75 Call Payout = $55Put Payout = $55
Why Lookback Options?
It eliminates the market entry and exit problems
Completely maximizes profit
Mini Quiz: Q1
The current price of a stock is trading at $2.50. The trader believes that the stock has high volatility and could rise above $2.55 or drop below $2.45. What is the best option to capitalize on this scenario?
A. Asian OptionB. Lookback OptionC. Binary OptionD. Double One-Touch Option
Double One-Touch
Mini Quiz: Q2
A trader buys a European call option with X = $100, that is trading at $100. The asset falls to $70 before rallying to $120. The trader decides to hold it to see if it will rally higher, but it falls to $80 at maturity. What option gives the highest payout?
A. Asian OptionB. Lookback OptionC. Binary OptionD. Double One-Touch Option
Questions
Sources http://www.optiontradingpedia.com/ http://www.investopedia.com/ http://www.thetaris.com/wiki/Look_Back_Option http://www.thetaris.com/wiki/Asian_Option Bermin, H., Buchen, P., & Konstandatos, O.
(2008). Two Exotic Lookback Options. Applied Mathematical Finance, 15(4), 387-402. doi:10.1080/1350486080201282