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