Exotic OptionsBA 543-001 Financial Markets and Institutions

Chavanun Yainuknaen (SEA)Spring 2013

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OutlinePut and call optionsExercise stylesFLEX optionsExotic optionsMarket and exotic options

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What is Option?A financial derivative that represents a contract sold by a

writer(seller) to a holder(buyer)

Grants the buyer the right, but not the obligation, to call or put a security or other underlying assets at the strike price during a certain period of time or on an exercise date

Option premium : The price paid to acquire the option

The expiration date or maturity date : The last day that an options is valid

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Types of Option Call option

The right to “buy”

Put optionThe right to “sell”

5Status of Call and Put Options

Call Option

Put Option

In the money

In the money

Out of the money

At the money At the money

Strike PriceStrike Price

Out of the money

Asset Price Asset Price

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Exercise StylesPlain options (Vanilla options)

American options European options

Exotic options Bermuda options Binary options Barrier options Lookback options Asian options Shout options Outperformance options Etc.

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Flexible Exchange Options (FLEX Options)

Does not have standardized features The writer and the buyer negotiate the specific terms The ability to customize key contract terms: o underlying, exercise prices, exercise styles, and expiration

dates

Written and guaranteed by the associated clearinghousePrice discovery in competitive and transparent auction

marketsA secondary market for an opportunity to offset or alter

positions before expiration

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Exotic options Non standard optionsCan be customized : FlexibilityCan be exercised at several

specified datesTrade in the OTC markets.Sometimes more expensive

than vanilla options

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Binary Option (Digital option)

Completely web-based Simple question :

What will the price of the underlying asset do next ?

To profit : Will the price go up or down? Correct Lose

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Binary Option

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Benefits of Binary OptionEasy and Simple – Choose the

direction of the value Controlled Risk – The percentage

reward is known from the beginningProtection – A safer option to take

if a trader has an open position elsewhere in currency, stocks etc.

Punctuality – Issued around the clock, allowing traders to trade on multiple time frames

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Lookback OptionAllow the option holder to trade with hindsightThe holder can look back at the price action and

exercise the option at the most advantages priceFixed Strike Lookback Option

Profit : (price at maturity – fixed strike price)Settled only in cash

Floating Strike Lookback OptionProfit : (price at maturity – the lowest strike price)

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Lookback Option

Fixed Strike Price Payout

Floating Strike Price Payout

Fixed Strike Time

14Benefits of Lookback OptionTake away of the problem of market

timingCompletely maximizes profits within the

life of the optionsBUT

Premium can be expensiveThe risk is when the underlying security does not move by enough

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Outperformance OptionBased on the relative payoff of 2 underlying assets at

the maturity datePayout = Max (rA – rB, 0) European and cash settledCan be written on equities, bonds, and currenciesPrimarily traded in the OTCIn the event the asset thought to outperform actually

underperforms, the payout is zero

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Outperformance Option

AppleS&P 500

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Outperformance Option

18Benefits of Outperformance Option Reduce the element of option price volatilityWhen the implied correlation between two assets

are greater than +0.5, then outperformance option is cheaper than a plain vanilla

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Why Market Evolved Exotic Options??

Meet specific and unusual needs of certain clients.Have tax, accounting, or regulatory advantages

over standard options.Allow an investment bank to sell an overpriced

product to its less technically sophisticated clients

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Takeaway PointsVanilla optionExotic options and benefits

Binary optionLookback optionOutperformance option

Market and exotic option

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References http://ezinearticles.com/?Options-Spread-Trading---So

me-Big-Advantages&id=3601431 http://thefinancialengineer.org/options-futures-other-d

erivatives/exotic-options/out-performance-option/ http://thismatter.com/money/options/exotic-options.ht

m http://web.ebscohost.com.ezproxy.proxy.library.oregon

state.edu/ehost/pdfviewer/pdfviewer?sid=3d6fca64-d58a-43de-aba6-3440e058c80e%40sessionmgr11&vid=33&hid=1

http://www.amex.com/servlet/AmexFnDictionary?pageid=display&word=Lookback%20Option

http://www.cboe.com/institutional/Flex.aspx http://www.derivicom.com/pages/Support/OnlineHelp/

FE_Dev/WebHelp/lookback_options.htm http://zantrio.com/article/5-really-exotic-options

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Questions ??

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Thank You