VALUING EXOTICS AND VANILLA OPTIONS

-Akshat Gupta (2022066)

VANILLA OPTIONS
Vanilla options are financial instruments that let their holders either buy or sell the underlying
asset at a “price that is determined at inception within a stipulated time period. The holder of a
vanilla option possesses the right to purchase or even sell the underlying without having an
obligation to do so. Whereas when it comes to the writer of the vanilla option, he/she shall
necessarily sell or even purchase, should the option writer decide to exercise his/her right.
TYPES OF VANILLA OPTIONS
• EUROPEAN- Exercised at Maturity
• AMERICAN- Can be Exercised anytime within the contract period
These can be further classified as:
• European Call - The holder has the right to buy underlying at a fixed price at expiry,
whereas the seller has the obligation to sell at that price (Strike).
• European Put - The holder has the right to sell the underlying at a fixed price at expiry,
whereas the seller has the obligation to buy at that price (Strike).
• American Call - The holder has the right to buy underlying at a fixed price on or before
expiry, whereas the seller has the obligation to sell at that price (Strike).
• American Put - The holder has the right to sell underlying at a fixed price on or before
expiry, whereas the seller has the obligation” to buy at that price (Strike).
(Corporate Finance Institute, n.d.)
EXOTIC OPTIONS
Exotic options are “financial instruments (option contracts) that are different from vanilla
options in terms of their:
• Expiry
• Exercise Prices
• Payoffs
• Underlying Assets
Exotic Options lie under the domain of Financial Engineering, which deals in developing
suitable pricing techniques and innovating new types of securities.
COMMON TYPES OF EXOTIC OPTIONS
• Asian Options – Option contracts whose payoffs are calculated by considering the
average price of the underlying asset for the last few periods (predetermined).
• Barrier Options – Contracts activate only if underlying asset’s price reaches a certain
level, i.e., breaks the barrier.
• Bermudan Options – These contracts are a combination of American and European
options. These contracts come with a choice to either exercise at expiry (like European)
or exercise at certain predetermined dates between purchase and expiry (similar to
American).
• Binary Options – These options ensure the payoff based on happening of certain events.
If that event happens, payoff is a predetermined fixed amount, Otherwise the option
expires worthless.

Akshat Gupta 2022066

 VALUING EXOTICS AND VANILLA OPTIONS
-Akshat Gupta (2022066)

• Chooser Options – Option holder has the right to decide whether the purchased option
is a call or a put on a fixed date” prior to expiry.
(Corporate Finance Institute - Exotic Options, n.d.)
VALUING OPTIONS CONTRACTS
Some commonly used methods to price options are:
• Black-Scholes Options Pricing Model
• Binomial Options Pricing Model
• Monte-Carlo Simulations
BLACK-SCHOLES OPTION PRICING MODEL
Black-Scholes model was developed by “Fischer Black and Myron Scholes to compute the
prices of the European Options. In this model certain assumptions are taken in order to
eliminate the risk factor.
These Assumptions are:
• Constant Volatility
• No Dividends
• Efficient Markets
• Returns are log-normally distributed
• Interest rates are constant and known
• No transaction costs and commissions
• Markets have enough liquidity
This model explains that a geometric Brownian motion is followed by the asset prices.
The inputs required in this model” are:
• Spot
• Strike
• Time to Maturity
• Risk free Interest Rate
• Implied Volatility
(ElearnMarkets, n.d.)
COMPUTATIONS FOR THE BLACK SCHOLES MODEL (Taking European Call as
reference)

Where:
C = Call Option Price
N =CDF of normal distribution
St = Spot Price
K = Strike Price

Akshat Gupta 2022066

 VALUING EXOTICS AND VANILLA OPTIONS
-Akshat Gupta (2022066)
r = Risk Free rate
t = Time to Maturity
σ = Volatility

BINOMIAL OPTIONS PRICING MODEL

Binomial Option Pricing Model or “BOPM is used in financial institutions to come up with a
value of option that can be deemed as fair. In this model, time to maturity of the instrument is
divided into steps/series of intervals. It can be used to price both Vanilla and Exotic Options.
At each step underlying asset’s price is assumed to increase or decrease. This assumption helps
generate a ‘Binomial Tree’ of possible asset prices at expiration.
BOPM has an edge over Black Scholes model because it can be adjusted so that various other
factors can be included in the analysis like dividends and interest rates. Secondly, unlike Black-
Scholes Model, this model can be used to handle American Options as well, which unlike their
European counterparts, can expire any time before or on expiry.
CALCULATION
The BOPM's calculations are based on the idea of risk-neutral valuation. This requires building
a binomial pricing tree and then figuring out the option price. Starting with the underlying
asset's current price, the binomial tree option pricing is constructed by making two branches,
one for an upward and one for a downward price movement, at each time step. An up-factor
and a down-factor, which are derived based on the asset's volatility and the duration of the time
step, define the size of these moves.
The option price is derived by going backwards from the last nodes of the price tree to the
present. The option price is calculated at each node by discounting the projected future value
of the option while accounting for the risk-free interest rate” and the likelihood of both price
increases and decreases.
(Angel One, n.d.)
MONTE CARLO SIMULATIONS
In this method, “A set of random variables are created by a Monte Carlo simulation that have
characteristics resembling the risk factors it is attempting to represent. Numerous potential
outcomes are generated by the simulation, along with their probability. In conclusion, it is
employed to model Options prices and other realistic scenarios.
This method can be used to price both vanilla and exotic options.
A huge number of simulations are run concurrently during a Monte Carlo test. Random changes
are summed up starting with the asset's current value, one for every period of time. Once the
exercise date has been reached, potential future asset values are determined, and from them,
the associated option prices are calculated in accordance with the termination condition (in this
case, max(ST-K, 0)). The data are then combined into a single mean value and discounted to
the present day.

Akshat Gupta 2022066

 VALUING EXOTICS AND VANILLA OPTIONS
-Akshat Gupta (2022066)
The model consequently has six parameters: S, the initial share price, K, the strike price, r, the
domestic risk-free interest rate, and q, the foreign security's risk-free interest rate. Time is the
date of expiration, is the rate volatility, and N is the total number of simulations” runs.
This model can be executed using programming languages such as Python or using Excel VBA.
(ResearchPaper by Hamid Shahbandarzadeh1*, Khodakaram Salimifard2, Reza Moghdani3 in
Iranian Journal of Management Studies (IJMS), n.d.)

References
1. (n.d.). Retrieved from Corporate Finance Institute:
https://corporatefinanceinstitute.com/resources/derivatives/vanilla-option/
2. (n.d.). Retrieved from Corporate Finance Institute - Exotic Options:
https://corporatefinanceinstitute.com/resources/derivatives/exotic-options/
3. (n.d.). Retrieved from ElearnMarkets: https://www.elearnmarkets.com/school/units/basics-of-
options/black-scholes-pricing-model
4. (n.d.). Retrieved from Angel One: https://www.angelone.in/knowledge-center/futures-and-
options/binomial-option-pricing-model
5. (n.d.). Retrieved from ResearchPaper by Hamid Shahbandarzadeh1*, Khodakaram Salimifard2,
Reza Moghdani3 in Iranian Journal of Management Studies (IJMS):
https://www.sid.ir/EN/VEWSSID/J_pdf/5063020130101.pdf
6. Corporate Finance Institute. (n.d.). Retrieved from
https://corporatefinanceinstitute.com/resources/derivatives/vanilla-option/
7. Hamid Shahbandarzadeh1, K. S. (n.d.). Retrieved from
https://www.sid.ir/EN/VEWSSID/J_pdf/5063020130101.pdf

Akshat Gupta 2022066