10 - Exotic derivatives Flashcards

Question

Why lookback options?

Answer 1

Lookback options combine the best features of American and European options. * The holder of an American option can take advantage of favorable prices prior to maturity by exercising the option early. * Lookbacks offer considerably more protection to the holder than do vanilla options. * But by the same token, they are typically very expensive thus not very heavily traded.

Answer 2

A shout option is a European option where the holder can ‘‘shout’’ to the writer at one time during its life. * At the end of the life of the option, the option holder receives either the usual payoff from a European option or the intrinsic value at the time of the shout, whichever is greater. * Final payoff is: max(ST – S , 0) + S – K

Answer 3

Asian options are options where the payoff depends on the arithmetic average of the price of the underlying asset during the life of the option. * Average Price options pay: * Call: max(Save – K, 0) * Put: max(K – Save , 0) * Average Strike options pay: * Call: max(ST – Save , 0) * Put: max(Save – ST , 0) 43 Asian Options…No exact analytic valuation * Can be approximately valued by assuming that the average stock price is lognormally distributed Why Asian Options? * exposure to the average * Asian options “smooth” the data * Are viewed primarily as instruments for hedging rather than speculation

Answer 4

Options to exchange one asset for another (sometimes referred to as exchange options) arise in various contexts. * An option to buy yen with Australian dollars is, from the point of view of a US investor, an option to exchange one foreign currency asset for another foreign currency asset. * A stock tender offer is an option to exchange shares in one stock for shares in another stock Options to exchange one asset for another (sometimes referred to as exchange options) arise in various contexts. * An option to buy yen with Australian dollars is, from the point of view of a US investor, an option to exchange one foreign currency asset for another foreign currency asset. * A stock tender offer is an option to exchange shares in one stock for shares in another stock

Answer 5

Quanto options are cross-currency options in which the option is written on a security that trades in one currency but the payoff is translated into a different currency in a prespecified manner. Example: * Suppose a US-based investor wishes to buy a call option on a French company whose shares trade in Paris in euros. Then, since the option trades in euros, the investor must bear currency risk at the end of the transaction: if the call finishes in-the-money, the profit from the call is realized in euros and must be converted back to US dollars at the then-prevailing exchange rate. If the investor does not want to bear this exchange-rate risk, she can buy an option in which the euros are converted back into US dollars at a fixed, prespecified exchange rate. Such an option is a quanto

Answer 6

Options involving two or more risky assets are sometimes referred to as rainbow options. * Examples: European basket option: this is an option where the payoff is dependent on the value of a portfolio (or basket) of assets. The assets are usually either individual stocks or stock indices or currencies. A European basket option can be valued with Monte Carlo simulation, by assuming that the assets follow correlated geometric Brownian motion processes

Answer 7

Ladder options are designed for investors who want to get exposure to the upside of a stock while at the same time locking in the performance of the stock if it ever goes above certain levels. * This type of option is particularly popular among retail investors and is typically structured as a capital guaranteed note with unlimited upside participation and the added advantage that a certain performance is guaranteed once the stock goes above a certain level.

Answer 8

The outperformance option measures the outperformance, whether it be on the upside or downside, of one stock against another and pays this difference. * Obviously, an outperformance option can also be structured between two different assets, like a stock and the oil price, in which case it measures the outperformance of the stock against the oil price. * The beauty of outperformance options is that their pricing and risks look complicated but can easily be understood when comparing them to a composite option

Answer 9

Volatility swap is agreement to exchange the realized volatility between time 0 and time T for a prespecified fixed volatility with both being multiplied by a prespecified principal * Variance swap is agreement to exchange the realized variance rate between time 0 and time T for a prespecified fixed variance rate with both being multiplied by a prespecified principal * Daily return is assumed to be zero in calculating the volatility or variance rate

Answer 10

This involves approximately replicating an exotic option with a portfolio of vanilla options * Underlying principle: if we match the value of an exotic option on some boundary, we have matched it at all interior points of the boundary * Static options replication can be contrasted with dynamic options replication where we have to trade continuously to match the option

Answer 11

In some cases, exotic options are easier to hedge than the corresponding vanilla options (e.g., Asian options) * In other cases, they are more difficult to hedge (e.g., barrier options)