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Accounting for Derivatives

The no net premium requirement may create illogical situations like the following: An
entity may buy an option today with the objective of selling another option at a later date
once the sold option becomes more valuable. If the premium of the sold option was larger
than the premium of the bought option, IAS 39 forbids designating the combination of
the purchased and the sold options as a hedging instrument.

2.5 EXOTIC OPTIONS

As was mentioned earlier, there are two types of options: vanilla and exotic options. Vanilla
options, also called standard or regular options, have all their terms fixed and predetermined
at their start. Exotic options group any other options that are not considered to be vanilla. In
general, exotic options have some terms that depend on specific conditions being met during
their life. The rationale behind most exotic options is to have a lower premium than their
vanilla equivalents.
It is not easy to classify the exotic options into small groups because their characteristics
are very wide-ranging. Also, it would be unrealistic to try to list all the different exotic options
being developed, as banks come up continuously with new ones. However, if we were to
provide some sort of categorisation, we would use the following classification:
Path-dependent options. The payoff of a path-dependent option depends on how the underlying price (or rate) has traded over the life of the option. The most popular path-dependent
options are average-rate options, barrier options, and range accrual options. Average rate
options, also called Asian options, are options with payoffs determined by some averages of the underlying price (or rate) during a pre-specified period of time before the
option expiry. Barrier options are the most popular exotic options and we will cover them
in detail next. Range accrual options are options with payoffs determined by the number
of days that the underlying stays within a specific range during a pre-specified period of
time.
Correlation options. The payoff of a correlation option is affected by more than one underlying. The most popular correlation options are basket options, quanto options and spread
options. Basket options are options on a portfolio of underlyings. Quanto options are options
with payoffs denominated in one currency whose underlying is denominated in another currency. Spread options are options with payoffs determined by the difference of two prices
(or indices or rates).
Other types of exotic options. This broad category groups all other options not included in
the previous two categories. The most common options in this category are digital options.
Digital options are options with payoffs that are either a fixed amount of cash (or other
asset) or nothing.

2.6 BARRIER OPTIONS

The most popular type of exotic option is the barrier option. Barrier options allow entities to
tailor their hedging strategies to very specific market views. The payoff of a barrier option
depends on whether the price of the underlying crosses a given threshold, called the barrier,
before maturity.