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Aaron Bany May 21, 2013 BA 543-002 Financial Markets and Institutions. Exotic Options. What is an option?. A financial derivative that represents a contract sold by one party (writer) to another party (holder) - PowerPoint PPT Presentation

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Exotic OptionsAaron BanyMay 21, 2013BA 543-002 Financial Markets and InstitutionsWhat 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 metHow Options FunctionOption = f(S, K, T, rf, )

S = share priceK = strike priceT = time to maturityrf = risk free rate = volatility of underlying asset2 Types of OptionsVanilla Options (2 forms)American OptionEuropean Option

Exotic Options (unlimited)Bermuda OptionsChooser OptionsPerformance OptionsCompound OptionsBinary OptionsBarrier OptionsAsian OptionsLookback OptionsEtc.

Exotic OptionsThe 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 OptionsIt either pays out or it doesnt2 typesCash-or-NothingPays the fixed amount if the asset is in-the-moneyAsset-or-NothingPays the value of the underlyingBarrier Options: Knock-InUp-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 = $0Scenario 2Time = 1 dayStrike Price = $80Barrier Price = $90Closing Price = $95Call Payout = $15Barrier Options: Knock-OutUp-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 = $5Scenario 4Time = 1 dayStrike Price = $80Barrier Price = $90Closing Price = $95Call Payout = $0Barrier Options

Double One-TouchDouble No-TouchOne-TouchNo-Touch

Why Binary and Barrier Options?You dont 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 priceAsian OptionsOriginated 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 valueAsian Option Example

Fixed StrikeFloating StrikeAverage = $102Pre-Set Strike = $80Call Payout = $22Put Payout = $0Average = $102Strike @ maturity = $110Call Payout = $0Put Payout = $8Why 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 priceLookback OptionsPayout 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 valueLookback OptionsFixed StrikeFloating Strike

Pre-Set Strike = $95Highest Price = $130Call Payout = $35Lowest Price = $75 Put Payout = $20Highest 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: Q1The 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?Asian OptionLookback OptionBinary OptionDouble One-Touch Option

Double One-TouchMini Quiz: Q2A 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?

Asian OptionLookback OptionBinary OptionDouble One-Touch Option

QuestionsSourceshttp://www.optiontradingpedia.com/http://www.investopedia.com/http://www.thetaris.com/wiki/Look_Back_Optionhttp://www.thetaris.com/wiki/Asian_OptionBermin, H., Buchen, P., & Konstandatos, O. (2008). Two Exotic Lookback Options. Applied Mathematical Finance, 15(4), 387-402. doi:10.1080/1350486080201282

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