3 exotic options[1]

8/3/2019 3 Exotic Options[1]

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Introduction to Exotic Options

FX Derivatives Seminar27th November 2004

Raphael Drescher


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Derivatives

People generally use derivativesfor:

Hedging

Implementing a View

Hedge an exposure with aforward.

Advantage - no risk (except basis).

Disadvantage - lose opportunities

Hedge an exposure with anoption.

Advantage - keep opportunities.

Disadvantage - premium

Basis

Vo

latility

Value

EuropeanOption

AmericanOption

Early Exercise

Forward Spot

Standard Derivatives


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Exotic Options

What are Exotic Options ?

Non-standard options

Options with additional features or functionality

Path-dependent (most exotic options) Second / Third generation products

What Exotic Options are NOT

Options on exotic currency pairs

Cure for bad positions

High quality for low cost --> You get what you pay for


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What can be non-standard

The Type of Option

Doesnt have to be a Call nor a Put

payoff may be a a fixed amount or Max[0 , f()], or...

The Underlying may not be a traded underlying, e.g., volatility

The Underlying Price

may be an average price or a maximum price

The Strike Price

may be an average price or a maximum price

Conditional Events payoff may depend on spot trading within a range, above/ below certain

levels

Payout may be in an other currency


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Exotics : Why do we need them ?

More cost effective products

Dont pay for hedging you dont need

Reduction of premium at risk

Greater scope to express specific views

Provide optical value

Embed spot views into hedging strategies

Greater gearing/leverage for speculative strategies

But bad product choices can cause problems

Spot Forwards Options Exotics


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Barrier Options

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SECTION 1

Path dependent

Spot

Time


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Barrier Options I

The value of a standard option is related to the expected futurevalue (intrinsic value)

The value of a barrier option is as well related to the expectedfuture value under either one or both of the following conditions:

The outstrike has never been touched during lifetime of theoption

The instrike has been touched during lifetime of the option

The payout (intrinsic value) of a barrier option is exactly the sameas the one of a standard option, again under the condition thatthe outstrike is never reached or the instrike is touched.


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Barrier Options II

Prices of barrier options are also influenced - besides outstrikes orinstrikes - by spot, strike price, interest rates, time till expirationand implied volatility, although in a complete different mannerthan for standard options

Risk parameters (Delta, Gamma, Tau, etc.) might be significantlydifferent than those of standard options

This fact has implication in terms of risk management for both,the client and the bank

and makes those options look attractive

better hedging variations with exotic options possibility of expressing a market view through different strategies

tailor made zero upfront premium strategies

leverage of exotic options are very big more delta for less premium


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Barrier options terminology

Options with OUT- strikes:

The option starts active

Down-and-out: Barrier lies below the spot

The option deactivates if the spot price drops below the barrier Up-and-out: Barrier lies above the spot

The option becomes inactive if the spot rises above the barrier

Options with IN- strikes

The option starts inactive

Down-and-in: Barrier lies below the spot

The option only activates if the spot price falls below the barrier

Up-and-in: Barrier lies above the spot

The option activates only if the spot rises above the barrier


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100 Vanilla Call

Spot at expiry above 100 = Option has a value

Spot at expiry below 100 = Option has Zero Value

S=K=100

117.50

112.50

102.50

107.50

92.50

97.50

87.50

82.50


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100 Vanilla Call

Spot can take different paths to end at the same level

Payout does not depend on what path spot followed

Payout 7.50

S=K=100

117.50

112.50

102.50

107.50

92.50

97.50

87.50

82.50


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100 Call with Knock Out at 97.50

Extra condition for payout to occur applies

Smaller probability of payout

Payout is path dependant

= Premium discount

S=K=100

Outstrike = 97.50

117.50

112.50

102.50

107.50

92.50

97.50

87.50

82.50


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Knock-Out Options: Vanilla versus Knock-Out

Standard Call Option

StrikeOX

Spot

Knock Out Call Option

Strike

Spot

Strike

Spot

Standard Put Option

Strike OX

Spot

Knock Out Put Option

Barrier is placed in the OTM direction


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Knock Out option is 23% cheaper than a Plain Vanillaoption(1.3200 EUR Call, 3mths, costs 175 USD pips)

If the EURUSD rate touches once 1.2750 over the next 3

months, the option expires immediately

If the Outstrike of 1.2750 is not reached, the Knock Outoption behaves like a Standard option at expiration

Knock-Out Options: EURUSD (Hedger Example)

Assumption:

Strategy:

Analysis:

Customer needs to buy EUR and wants to protect himselffrom a adverse market move, e.g. a higher EUR againstUSD; spot CHF 1.3000 per 1 USD

Buy a 1.3200 USD Call / CHF Put, Outstrike 1.2750,expiration 3 months, amount USD 10m.

Premium 135 CHF pips (0.0135 USD per 1 EUR)


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If the OX is touched, the option and thus the protection ceases to exist.The hedge is no longer in place

But we get a chance to rehedge on a better level

either through a new Call (with OX) or by linking a Spot Buy Order to the OX initially

Summary: The Knock Out Call gives opportunities to rehedge at morefavourable levels, but monitoring and action is needed

Reasons for using a Knock Out Option Lower premium

Greater benefit from a move in spot (higher delta)

Option only exists when needed

Alternative names used: Up-and-Out

Down-and-Out

Knocked-Out... Is this good or bad?


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Kick-Out Options: Vanilla versus Kick-Out

Standard Call Option Standard Put Option

Kick Out Put Option

Strike

Spot

Strike OX

Spot

Kick Out Call Option

StrikeOX

Spot

Strike

Spot

Barrier is placed in the ITM direction


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Kick-Out Option: EURUSD (Investor Example)

Kick Out option is 60% cheaper than the plain vanillaoption(1.3200 EUR Call, 3mths, costs 175 USD pips)

If the EUR/USD rate rises at or above 1.4000 over the next3 months, the option expires immediately.If the outstrike of 1.4000 is never touched, the Kick Outoption behaves like a standard option at expiration

Assumption:

Strategy:

Analysis:

Customer anticipates a higher EUR against the USD towards1.4000 but not above and wants to profit from thismovement; Spot USD 1.3000 per 1 EUR

Buy a 1.3200 EUR Call/USD Put, Kick-Out 1.4000, expiration3 month, amount EUR 10m.

Premium 70 USD pips (0.0070 USD per 1 EUR)


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Long Kick-Out Option: EUR/USD (Investor Example)

-0.0200

0.0000

0.0200

0.0400

Strike

Outstrike

0.0600

-0.0400

SpotEURUSD

Exotic Option:

Kick Out Call Vanilla

Value atexpiration

1.3200 1.3300 1.3400 1.3500 1.37001.3600 1.3800

0.0800

1.4000


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Kick Out Option

Reasons for using a Kick Out Option

Very low Premium in exchange for potential give up

Expresses mildly bullish/bearish view

Benefit from high Volatility levels (Long Kick Out = Short Volatility)

Benefit from stable spot market (Long Kick Out = Earn Decay)

Alternative names used:

Reverse Knock-Out Option


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Kick-In Options: Vanilla versus Kick-In

Standard Call Option Standard Put Option

Kick In Put Option

Strike

Spot

IX

Kick In Call Option

Strike

Spot

Strike

Spot

Strike

Spot


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Kick-In Option: EURUSD

Kick In option is 8% less rich in premium than theplain vanilla option(1.3000 EUR Put, 2mth, receive 250 USD pips)

If the EURUSD rate falls at or below 1.2600 over thenext 3 months, the option becomes alive andbehaves like a standard option at expiration. If theinstrike of 1.2600 is never touched, the Kick In

option does not exist at the expiry date.

Assumption:

Strategy:

Analysis:

Customer anticipates a somewhat higher EUR againstthe USD in the next couple of weeks in a volatileenvironment. Spot USD 1.3000 per 1 EUR

Sell a 1.3000 EUR Put/USD Call, Kick-In 1.2600,expiration 3 month, amount EUR 10m.

Premium receive 230 USD pips (0.0230 USD per 1 EUR)

K k I O


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Kick In Option

Reasons for using a Kick In Option

Option buyer

Lower premium

Hedge appears only when needed

Fits view of a sharp move in spot

Option seller

Alternative to selling Standard Option

Collect premium with no obligation if Instrike is not breached

Often used in Risk Reversal Strategies


Reverse Knock-In Option


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Payout Options

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SECTION 2

Options that pay out an amount

depending on certain parameters

O T h O ti


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One Touch Option

What is a One Touch?

Pays a fixed amount if Trigger is touched during life of option

Quoted as % of Payout (Pay 20% - receive 100% if touched)

Reasons for using a One Touch Option

One Touch buyer:

Strong directional view

Fixed Risk-Reward

One Touch seller:

Alternative to short Standard Option in Risk Reversal

Limited downside

Alternative names used: Binary Option

Lock-In Option

American Digital Option

O T h E l


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One Touch Example

Right to receive fixed payout of 100,000 EUR

Pays out if spot reaches 1.3700 before expiration

The up front premium is 30% of payout (30,000 EUR)

Market Data Product Data

EURUSD Expiry: 3 month

Spot: 1.3000 Payout: 100,000 EUR

Trigger: 1.3700

Premium: 30% of payout

O T h


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One Touch

-30%

0%

30%

60%

90%

1.26 1.28 1.30 1.32 1.34 1.36 1.38

Spot at Expiration

%EU

RPayout

No Touch Option Double Lock Out


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No Touch Option Double Lock Out

What is a No Touch Option?

Pays a fixed amount if Trigger is NOT touched during life of option

Quoted as % of Payout (Pay 20% - receive 100% if not touched)

One Touch and No Touch prices are connected

Probability of NOT touching + Probability of touching = 100%

Price of One Touch + Price of No Touch = 100%

P/L of buying a One Touch Option is the same as selling the NoTouch Option with the same trigger

Pay outs can be @ touch or @ maturity

Double No Touch Option


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Double No Touch Option

What is a Double No Touch ?

The Double No Touch Option pays a pre-specified payout amount ifand only if Spot does not touch either of the two Outstrikes duringthe life of the option

Reasons for using a Double No Touch Option

Benefit from range bound spot market

Short Volatility with limited downside (premium)

Fixed Risk-Reward Earn time decay as time moves on


Double Lock-Out Option Range Bet

Range Binary

Double No Touch Option Example


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Double No Touch Option Example

Right to receive fixed payout of 100,000 USD.

Pays out if spot does not reach 99.0 or 106.0 before expiration.

Up front premium is 20% (20,000 USD)

Option will decay in your favour (from 20,000 to 100,000).

Market Data Product Data

USD/JPY Expiry 3 month

Spot: 103.00 Payout 100,000 USD

Outstrikes 99.0 & 106.0

Premium 20% of payout

Double No Touch


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Double No Touch

-40%

-20%

0%

20%

40%

60%

80%

100%

95 97 99 101 103 105 107 109 111

Spot at Expiration

%U

SDPayout

Digital options


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Fixed payout made at expiry if spot finishes ITM with respect tostrike

Also known as

Binary Options All-or-Nothing Options

Cash-or-Nothing

Asset-or-Nothing Options

Digital Call:

Digital Put

X

Pay-outat

expiry

Spot at expiry

X

Pay

-outat

e

xpiry

Spot at expiry

Digital options

Rule of thumb: Digital price = of OneTouch price

3m EURUSD 1.3700 Digital Call costs 17%

You pay EUR 17,000 today and get EUR100,000 at expiry if EURUSD trades at orabove 1.3700 at expiry.


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Multiple Assets and other Exotics

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SECTION 3

Multiple Assets

A

Ccy 1

Ccy 2

BC

D

Ccy 3

Multiple assets


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Multiple Assets

A

Ccy 1

Ccy 2

BC

D

Ccy 3

Multiple assets

The value of single asset optionsonly depends on the price of oneunderlying currency pair

The value of a multiple assetoption depends on more thanone currency pair

Basket Options

Quanto Options

Basket Options


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Basket Options

A basket option gives the holder the right to exchange onecurrency for a portfolio of currencies

A basket option can be designed so that the holder has the right

to buy all the basket currencies, sell all the basket currencies, orhave mixed cash flows against the base currency

Basket options are less expensive than the sum of the individual

vanilla options

The basket option discount to thevanillas is driven by the correlationbetween the basket of currenciesand the base currency

Managing a Portfolio of Currencies

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

-1 -0.5 0 0.5 1

Correlation

BasketPrice

[%USD]

Sum of premiumsof vanilla options

Premium ofbasket option

The Impact of Correlation on the Basket Price

Basket Options - Example


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Basket Options Example

A EUR based Asset Manager wants to hedge the following globalportfolio on 1yr time horizon:

The ATMS EUR Basket Value is 138.8m

Buy a Basket Put/ EUR Call, strike 138.8 for EUR 2.1m (1.5%) If at expiry the Fixed Currency amounts yield less than EUR 138.8m you

will exercise the option to sell the Basket Fixed Currency Amounts forEUR 138.8m

Sum of the vanillaoptions costs EUR 3.4m (2.4%)

Managing a Portfolio of Currencies

36%

30%

21%

13%

EUR

USD

GBP

JPY

local ccy FX in EUR in %

EUR 50 50 36%

USD 50 1.2200 41.0 30%

GBP20 0.6830 29.3 21%

JPY 2,500 134.85 18.5 13%

138.8

Basket Value

EUR 138.8mEUR 125m EUR 150m

PnL

Quanto Options


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Quanto Options

A Quanto option is an option where any payout at expiry isconverted to a third currency at an FX rate fixed on trade date.

Buyer has the right to exercise the option (just like a vanilla) but is

obligated to receive any payout in the quanto currency.

Example:

Client looking to take a position in EURJPY does not wish to have

currency exposure on the option payout With a vanilla option, if the EURJPY option is in-the-money at expiry,

the client would receive JPY payout

Would convert into USD at the prevailing USDJPY exchange rate

Payout could have been eroded by a weakening JPY vs. the USD

To eliminate this USDJPY risk, the client could purchase a EURJPYoption quantoed into USD, where the JPY payout is convertedinto USD at a USDJPY rate chosen at the time of trading

Hedges an exposure into a 3rd currency

Quanto Options - Example


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$.70m

$.80m

$.90m

$1.0m

$1.10m

$1.20m

$1.30m

85 90 95 100 105 110 115 120 125 130

QuantoNon-Quanto

6-month 135.00 strike EUR Call / JPY Put

The JPY payout can be converted into USD at a Quanto Strike of100.00 JPY per USD

Price:

Vanilla 135.00 EUR Call: 2.00%

Quanto 135.00 EUR Call

with 100 quanto strike: 2.30%

Payout: At expiry, EURJPY spot is at 145.00 and USDJPY spot is at 120.00

JPY Payout of EUR Call: JPY10 per EUR on 10m, or JPY 100m,converted to USD at the quanto strike of 100 gives a USD payout of$1m

If the USD-based client had used a vanilla option, their JPY optionpayout converted to USD at 120 would only have been $833k a 16%

reduction

Q p p

USD Payout at Expiry

Situation: A USD-based client wanting to play a bullish EURJPY view

Result: Client protected the USD value of option payout

Benefits of the quanto option


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q p

The attractive feature of a quanto option is that the JPY payoutcan be converted to USD at 100, regardless of

USDJPY exchange rate at expiry

JPY payout amount at expiry

If EURJPY were 140 at expiry, and the JPY payout had been JPY200m, that amount could still be converted to USD at the quantostrike of 100

A quanto option can be thought of as a quantity adjustingoption, providing currency protection on a notional not knownuntil expiry

Hedge an unknown notional the optionpayout in your non-home currency!

Vanilla or Exotic Options The choice is yours!


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p y

Whats your scope in the Foreign Exchange Market? e.g. are your a Hedger, an Investor or a Yield Enhancer?

What are your expectations?

Spot-Market moves up/down/sideways?

Volatility moves up/down/sideways?

Timing? (Windows)

Whats your risk appetite?

Long versus short position or a combination thereof?

Desired leverage factor


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3 exotic options[1]

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