FMP15 - Exotic Options

Question 1

Define and contrast exotic derivatives and plain vanilla derivatives

Answer 1

Exotic options are non-standard designed specifically to meet needs, can provide more efficient hedging than plain vanilla

Question 2

Explain how any derivative can be converted into a zero-cost product

Answer 2

Arrange for it to be paid for in arrears, buyer pays f(1 + R)^T at maturity

Question 3

Describe how standard American options can be transformed into non-standard American options

Answer 3

Variations make them non-standard;
- Bermudan when exercising restricted to certain period
- Initial lock out period where it can not be exercised
- Strike varies over lifetime of option

Question 4

Identify and describe the payoff structure of the following exotic options: gap, forward start, compound, chooser, barrier, binary, lookback, Asian, exchange, and basket options

Answer 4

• Gap: strike used for calculating payoff is separate to the strike
• Forward start: option begins at a future date
• Compound: essentially options on other options for extra leverage. Example, option for T1 and K1 to buy an option for K2 at T2
• Chooser: period of time where buyer can choose if call or put
• Barrier: option comes into / out of existence if asset price reaches a certain barrier
• Binary: cash/asset or nothing if option in the money at the time of maturity
• Lookback: payoff depends on minimum / maximum asset price during the life of the option
• Asian: payoff depends on average over the life of the option
• Exchange: gives holder right to exchange one asset for another
• Basket: option on a portfolio of assets

Question 5

Describe and contrast volatility and variance swaps

Answer 5

Volatility swap is where trader agrees to swap predetermined volatility with realised volatility at maturity. Variance swap is the same but with variance

Question 6

Explain the basic premise of static option replication and how it can be applied to hedging exotic options

Answer 6

If two portfolios are worth the same at some boundary, they must also be worth the same at all interior points.

Therefore if a portfolio of vanilla options worth the same at some boundary as exotics, exotics can be hedged by shorting the portfolio.