chapter 26 Exotic options Flashcards
What are exotic options?
Exotic options are nonstandard derivative products created by financial engineers that are generally much more profitable than plain vanilla options. They are developed for a variety of reasons, including hedging needs, tax, accounting, legal, or regulatory reasons, and to reflect a view on potential future market movements.
How should the yield rate be set for different underlying assets when valuing options?
For an option on a stock index, the yield rate should be set equal to the dividend yield on the index. For an option on a currency, it should be set equal to the foreign risk-free rate, and for an option on a futures contract, it should be set equal to the domestic risk-free rate. Many of the options discussed in this chapter can be valued using the DerivaGem software.
What is a package in the context of derivatives trading?
A package is a portfolio consisting of standard European calls, standard European puts, forward contracts, cash, and the underlying asset itself. Different types of packages include bull spreads, bear spreads, butterfly spreads, calendar spreads, straddles, and strangles. Often, packages are structured to have zero initial cost.
What is a Bermudan option?
A Bermudan option is a type of American option with restricted early exercise that can only take place on certain dates during the life of the option.
What is a lock-out period in the context of American options?
A lock-out period is an initial period of time during which early exercise is not allowed for an American option. After the lock-out period, early exercise may be allowed for the remainder of the option’s life.
How are nonstandard American options usually valued?
Nonstandard American options can usually be valued using a binomial tree. At each node of the tree, the test for early exercise is adjusted to reflect the terms of the option, such as the restricted exercise dates or changing strike price.
Gap call option
Definition: A European call option that pays off ST - K1 when ST > K2
Difference from regular call option:
Increased payoff when ST > K2 by K2 - K1
Positive or negative increase depending on whether K2 > K1 or K1 > K2
Gap call options have a higher potential payoff compared to regular call options when the underlying asset price exceeds K2 by a margin of at least K2 - K1.
Gap call options may be useful in certain market situations, such as when there is an expected sharp movement in the asset price.
Forward start option
Definition: Options that start at a specified future time
Example: Employee stock options granted at-the-money to employees at a future date
Forward start options are a type of derivative that allows investors to hedge against future market fluctuations.
Forward start options can be used to protect against uncertainty in the market or lock in a favorable price.
Cliquet option
Definition: A series of call or put options with rules for determining the strike price
Structure example: First option has K equal to the initial asset price and lasts from 0 to t1. Second option provides a payoff at t2 with a strike price equal to the asset value at t1, and so on.
Valuation: The n-1 forward start options can be valued as described in Section 26.5.
Cliquet options are a type of exotic option that provides investors with more flexibility and customized risk management.
The structure of the cliquet option can vary widely, and the valuation can be complex. Monte Carlo simulation is often used when analytic results are not available.
Compound option
Definition: Options on options
Types: Call on a call, put on a call, call on a put, put on a put
Strike prices: Two
Exercise dates: Two
Compound options are a complex type of derivative that can provide investors with more flexibility in managing risk.
Compound options can be useful in situations where there is high uncertainty about the future direction of the underlying asset price.
Barrier option
Definition: Options where the payoff depends on whether the underlying asset’s price reaches a certain level during a certain period of time
Types: Knock-out and knock-in options
Advantage: Less expensive than corresponding regular options
Barrier options are a popular type of derivative that can be used to hedge against sudden market movements.
The type of barrier option chosen will depend on the specific market situation and investor goals.
Binary/digital option
Definition: Options with discontinuous payoffs
Example: Cash-or-nothing call, pays off nothing if asset price is below strike price at maturity and fixed amount Q if above
Put option example: Cash-or-nothing put, pays off Q if asset price is below strike price
Binary/digital options are a type of derivative that can be useful for investors who want to limit their downside risk.
Binary/digital options have a fixed payout, making them a good choice for investors who are looking for a simple way to manage risk.
Lookback option
Definition: Payoff depends on maximum or minimum asset price reached during the life of the option
Floating lookback call: Payoff is amount that final asset price exceeds minimum asset price achieved during the life of the option
Floating lookback put: Payoffs depend on the maximum or minimum asset price reached during the life of the option. A floating lookback call pays the difference between the final asset price and the minimum asset price achieved during the life of the option, while a floating lookback put pays the difference between the maximum asset price achieved during the life of the option and the final asset price.
Shout options
European options 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.
Average price options
Payoffs depend on the average price of the underlying asset. The payoff from an average price call is max(S - K2, 0), while that from an average price put is max(K - S, 0), where S_ave is the average price of the underlying asset. Average price options tend to be less expensive than regular options and are more appropriate than regular options for meeting some of the needs of corporate treasurers.
