Exotic OptionsBA 543-001 Financial Markets and Institutions

Chavanun Yainuknaen (SEA)

Spring 2013

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Outline

Put and call options

Exercise styles

FLEX options

Exotic options

Market 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 optionThe 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 Price

Strike Price

Out of the money

Asset Price Asset Price

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Exercise Styles

Plain 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 clearinghouse

Price discovery in competitive and transparent auction markets

A secondary market for an opportunity to offset or alter positions before expiration

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Exotic options

Non standard options

Can be customized : Flexibility

Can be exercised at several specified dates

Trade 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 Option

Easy and Simple – Choose the direction of the value

Controlled Risk – The percentage reward is known from the beginning

Protection – 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 Option

Allow the option holder to trade with hindsight

The holder can look back at the price action and exercise the option at the most advantages price

Fixed Strike Lookback OptionProfit : (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 Option

Take away of the problem of market timing

Completely maximizes profits within the life of the options

BUT

Premium can be expensive

The risk is when the underlying

security does not move by enough

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Outperformance Option

Based on the relative payoff of 2 underlying assets at the maturity date

Payout = Max (rA – rB, 0)

European and cash settled

Can be written on equities, bonds, and currencies

Primarily traded in the OTC

In 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

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Benefits of Outperformance Option

Reduce the element of option price volatility

When 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 Points

Vanilla option

Exotic options and benefitsBinary optionLookback optionOutperformance option

Market and exotic option

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References

http://ezinearticles.com/?Options-Spread-Trading---Some-Big-Advantages&id=3601431

http://thefinancialengineer.org/options-futures-other-derivatives/exotic-options/out-performance-option/

http://thismatter.com/money/options/exotic-options.htm

http://web.ebscohost.com.ezproxy.proxy.library.oregonstate.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