# managing exotic options risk

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COMMONWEALTH OF AUSTRALIACopyright Regulations 1969

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Objectives

Overview of Vanilla and Exotic Options

Introduction to Exotic Options

Types of Exotic Options

Examples: Time Dependent Exotic Options.

Example: Path Dependent Exotic Option.

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Overview of Vanilla and Exotic Options

Options risk can be further sub-divided into two categories:

Plain Vanilla Options = risk of relatively liquid options

Exotic Options = risk of less liquid options (next audio).

Now from a risk management perspective, the risks associated with options has to do more with their liquidity properties rather than the complexity of the options contract struck.

However, from this liquidity constraint, exotic options form their own degree of complexity.

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Introduction to Exotic Options

Exotic options as defined by Allen (2013) relate to not necessarily the degree of complexity of the option or the complexity of the mathematical formula but the degree of market liquidity for the option.

Unlike Vanilla Options where we could use such models as the price-vol matrix to reduce risk by offsetting transactions in liquid options markets, with exotic options there is insufficient liquidity to obtain trading and pricing benchmarks.

Risks in exotic options therefore need to be reflected, where possible, in their vanilla option counterparts. There are a number of reasons for this. It: allows risk to be measured albeit with a residual risk that can

be better managed;

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Exotic Options

encourages risk to be managed with the vanilla options positions;

increases consistency in valuing risk;

creates consistent reporting mechanism and position summaries for management that are already used for vanilla options such as price-vol matrices, deltas etc.

In addition, and as noted in Topic 8, the Black-Scholes-Merton (BSM) model assumptions are not always true. Volatility can be uncertain and variable making it difficult for interpolating vanilla option volatility surfaces into an exotic option framework.

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Exotic Options Types

As such we need more complex methods to for exotic options based on the Vanilla options market. Approaches can be based on one of two of the following:

Static:

whereby the composition of Vanilla options used do not need to change throughout the life of the exotic option and;

Dynamic models:

whereby the composition of Vanilla Options used are adjusted throughout the life of the exotic option.

Exotic Options:

Single-payout options:

Payoff are a function of the underlying asset at a single future time.

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Exotic Options Types

Time-dependent options:

Payoff are a function of the Vanilla options price at a single future time.

Path dependent options:

Payoff are a function of the underlying asset at many single future time periods.

Correlation-dependent options

Payoff are a function of several underlying assets (taking into account the correlation between the assets).

Correlation-dependent interest rate options

Payoff are a function of several future interest rates.

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Time Dependent Options

We will briefly examine two critical areas (please refer to Allen (2013) for further details on the other exotic option types.

Time Dependent Options

Forward-starting:

A forward starting option depends on the at-the-money implied volatile of a vanilla option and a specified time. For example: a forward-starting option could be sold on April 1st 2014 for a one year at-the-money option to buy 1000 shares in XYZ that will start in November 1st 2014.

The strike is dependent on time and will be set when November 1st

2014 arrives. Therefore no underlying price exposure exists during that time but there is an implied volatility exposure impacting what the at-the-money option will set at on November 1st 2014.

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Time Dependent Options

Cliquet type Options:

A cliquet option (French pronounced click-a) is actually a package of forward-start options where as one option ends the other begins. For example, a cliquet option may consist of three-month forward start options beginning March 10, June 10, September 10, and December 10 2014. Each forward-start option can then be valued separately and then adding those values.

Compound Options:

A compound option gives the purchaser the right to but (sell) a vanilla option at a given strike price. It is also called a split fee option as the customer can split fee by paying a down payment and reduce cost and risk. The customer pays a down-payment to get an option exercised at a particular date that is less than what they can pay. If the underlying declines in value, the option will be unattractive (the customer saves as they have just paid a down-payment not the full cost). If the underlying increased the customer will pay more for the option than would he could have paid upfront at the start.

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Path-Dependent Options

Path dependent items are based on the prices of a single asset at many time periods.

They are the most common and form building blocks to form static hedges for other exotic options.

Figure 1 shows a typical barrier option in terms of a knock-outoption. A barrier option is equal to a standard call (put) but the payoff is a function of some price level trigger (the barrier) over some time period. Options that pay only if the option has not been breached are called knock-out options (obvious reason).

Other types of these options include knock-in options, and variations of knock-in and knock-out options including double barrier options which is a combination of both. There are also Asian options, look-back options inter-alia.

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Path-Dependent Options

Figure 1: Barrier options knock-out

asset price

up-barrier barrier level

timeknock-out

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Summary of Exotic Options

Exotic options provide:

increased flexibility for risk transfer and hedging.

highly structured expression of expectation of asset

price movements

facilitation of trading in new risk dimension such as the

correlation between key financial variables.

Note: small amount of liquidity or none at all. This means there isdifficulty with pricing, hedging, and replicating.

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