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4/17/12
Presentation
On
EXOTIC DERIVATIVES
Presented by:
Daisy Amchandwalia
Kasturi More
Payal Khandaliya
Jagdish Shanbaug Jaydeep
Dhandaliya
Sagar Patil
4/17/12
Exotic and derivatives

Derivativesare assets whose value

depends on
anotherunderlyingasset.

Exoticas opposed tovanillarefers

to the fact that the payoff is not
standard, as is the case for a regular
call option.

Exotic derivativesrefers to a
specific type of financial asset.
4/17/12
EXOTIC DERIVATIVES

In financial derivatives terminology,

the term Exotic Derivatives usually

refers to more complex, unusual and
specific derivative contracts that
depend on the value of some
underlying asset or defined set of
assets.

This term contrasts with the use of

Vanilla Derivatives to denote more
standard derivative contracts.
4/17/12

According to James Calvin Baker in

the book, "The Bank for International
Settlements," exotic derivatives, also
called exotic options and second
generation options, are non-standard
financial assets that are developed
specifically for a particular market or
client. Simply put, exotic derivatives
are all those derivatives that are
more complex than regular
derivatives.
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Exotic Option

Infinance, anexotic optionis

aderivativewhich has features
making it more complex than
commonly traded products (vanilla
options). These products are usually
tradedover-the-counter(OTC), or
are embedded instructured notes.

The term "exotic option" was

popularized byMark Rubinstein's
1990 working paper (published 1992,
with Eric Reiner) "Exotic Options"
4/17/12
Characteristics

Exotic derivatives are typically traded over-the-

counter; their valuation depends on underlying
options, such as equity and interest rate volatility;
are flexible and fully customizable to suit varying
needs of their end customers, require constant
monitoring when hedging and are difficult to value
and price than regular options.
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Purpose

Exotic derivatives are complex financial

instruments and risk management tools that were
introduced mainly to hedge specific risks.
According to the vice president of FEA software
firm in California, Carlos Blanco, as quoted in the
report titled "Power is Complex and Exotic," exotic
derivatives are potent tools that provide their
clients the flexibility to transfer and manage
business risks to other parties with different
degrees of risk tolerance or parties with natural
offsets.
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Types

There are many types of exotic

options

Binary options

Asian options

Barrier options (knock-in and knock-out)

Bermudian options

Forward start options

Compound options

Chooser options

Lookback options

Shout options
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Binary Option

One that makes a fixed payout if the

option finishes in the money, or pays
nothing if the option finishes out of
the money.

For example, if we have a digital call

option on gold with a strike of $1200.
If the price ends up at or above
$1200, the option is in the money,
and the owner receives a fixed
payout of $100.

If the option finishes below $1200,

the option holder receives nothing.

In this example, there are only two

possible outcomes, either $0 or
$100.

During the life of the option, it will be

priced somewhere between $0 and
$100 depending on the probability of
the option ending up in the money.

Types: In a cash or nothing binary,

a cash or nothing put, an asset or
nothing call, an asset or nothing
put
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Asian Option

One that pays out depending on the

average value of the asset over the
time period.

Assume we have a 3-month call

option on gold with a strike of $1200.
If over the 3 months the price of gold
averaged $1250, the option would
have a payout of $50.

Asian options tend to be less volatile

than standard options especially as
the options approach expiry.

Contrast this to a standard option,

whereby the payout is heavily
dependent on where the asset moves
towards the end of an options life.
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Asian Option

There are actually many variants of Asian

options available.
Average price call: max(0,Save-K)

Average price put: max(0,K-Save)

Average strike call: max(0,ST-Save)

Average strike put: max(0,Save-ST)

The method for calculating the average can vary.

Usually it is the arithmetic average, but can be the

geometric average.

The period of from which the average is taken

can vary tremendously:

Daily over life of the option.

Daily over last n days of options life.

Daily over first n days of options life.

Weekly, monthly, etc.

From specific days during the life of the option (perhaps

on the 15th of every month.)
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Barrier Option

One that pays out when a specific

level is hit. They can be structured in
a variety of ways.

For example, we could have a gold

option with a barrier of $1200.

If over the life of the option, gold

crosses $1200, the option is in the
money, and the holder receives a
payout.

They can also be structured so that

they start in the money and if a
particular level (i.e. barrier) is hit,
then the option is worthless.
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Barrier Option

Two general kinds:

Knock-in options: The option comes into

being only if the stock reaches a given
barrier during its life.

Knock-out options: The option ceases to

exist if the stock reaches a given barrier
during the options life.

Some examples:
Down-and-out call. This is a call with strike K
that ceases to exist if the asset price reaches
the barrier level H, where S0>H.

Down-and-in call. This is call with strike K that

comes into existence only if the stock price
reaches the barrier level.
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Barrier Option

Assume for a moment that you held

two portfolios:
o
Portfolio A: One call with strike K.
o
Portfolio B: One down and in call with
strike K and barrier H.
One down and out call with strike
K and barrier H.

At maturity there are two potential

states of the world, lets compare the
portfolio values in each:

The stock remained above the barrier at

all times (state 1).

A: Max(0,ST-K).

B: Down and In: 0 (never activated).

Down and out: max(0,ST-K)

The stock at some point touched the

barrier (state 2).

A: Max(0,ST-K)

B: Down and In: max(0,ST-K)

Down and Out: 0 (died when stock touched
barrier).
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Barrier Option

We can see, therefore, that the two

portfolios have the same terminal
values in all states of the world, so
they must be equal. Denote c as the
value of the normal call option at
time 0, cdi as the value of the down
and in option at time 0 and cdo as
the value of the down and out option
at time 0. Then,
c = cdi + cdo

So we really only need to determine

the value of one of these barriers to
determine the value of the other at
time 0.

Which of the two that we will choose to

solve depends upon the relationship
between K and H.

If H<=K, we value the down and in call

On the other hand, if H>=K, then value

the down and out call.
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Bermuda Options

A Bermuda option is a generic name

for an option that is in between an
American and a European option.

Usually these are options that allow early

exercise only on specific dates.

Sometimes they are options that do not

allow early exercise until a specific date
but then allow early exercise from that
point on. These are said to contain a
lock out period.

Sometimes they are standard options but

have a strike price that changes,
typically as a function of time.

Typically these are priced through a

binomial model.

Example: A non-dividend paying stock is

currently priced at $20, and you hold a put that
allows early exercise in 2 months and in 4
months. The option expires in 6 months.
Volatility is 30%, and r=5%. What is the value
of this option?
4/17/12
Bermuda Options

We will use the CRR binomial model.

First, we need to determine our
lattice parameters:
1
.3
12
1
.3
12
( )
1.090463
0.917042
and
1.00417 0.917042
0.502439
1.090436 0.917042
dt
dt
r dt
u e e
d e e
e d
p
u d

Since this is a rather long option, after

calculation, we get
The Bermuda option has a value of 1.47.
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Forward Start Options
A forward start option is one in which
the option is issued to you but
begins at some point in the future.

These are widely used in

employee/executive compensation
schemes.

Generally you are granted the option

today, but it does not become active
until some date in the future, T1. Usually
you would have to still be employed by
the firm at time T1, or your option would
not activate.

Usually these options are written such

that the strike is determined to be at
the money at time T1, that is, K=S1.

The option then expires at time T2.

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Forward Start Options

The key to developing a pricing

model is to realize that we know for
certain that the option will be at the
money at time T1.

We are assuming that other

parameters, such as r and are
constant.

The value of an at-the-money call option is

proportional to the stock price.

Example : Price a year, at the

money call option on a stock with
volatility of .30, and with risk free
rate of 5%. Price this option for
different values of S0 (and hence of
K).
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Forward Start Options

Here is a list of Black-Scholes prices

for S0 from 1 to 20.

The option price for S0>1 is just the

S0=1 price multiplied by the ratio of
the stock price to 1!
Stock & Strike Call Value
Ratio to Value
when S=1
1 0.096349 1
2 0.192697 2
3 0.289046 3
4 0.385395 4
5 0.481744 5
6 0.578092 6
7 0.674441 7
8 0.77079 8
9 0.867138 9
10 0.963487 10
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Forward Start Options

This means that for any given set of

values for r, , and T, if an option is
at the money, its value can be
related to any other at-the-money
option with the same r, , and T
values.

Denote c0 as the Black-Scholes value of

an at-the-money option at time 0, with
maturity T = T2-T1, on the stock, that is,
K=S0.

Since r, , at T do not change at time T1,

only S1 and K, I know that the value of
an at-the-money option at time T1 will
be:
c1=c0*(S1/S0)

Going back to the previous example, if

S0 were $5, then c0=0.481744. Thus, if
at time T1 S1=7, then we would expect
c1=0.481744*(7/5)=0.481744*1.4 =
0.67444.
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Forward Start Options
This is nice because it means that all we
have to do is to take determine the risk-
neutral expected value for this option
and discount it at the risk-free rate, i.e.:

Of course, S0 and c0 are known with certainty

at time 0, and the expected stock price at time
T1 under risk-neutrality is simply

Plugging in and simplifying yields:

1
1
_ 0
0
rT
forward start
S
c e E c
S

1
]

( )
1
( )
1 0
r q T
E S S e

1
_ 0
qT
foward start
c c e

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Compound Option

A compound option is simply an

option to buy an option. There are
four types of these options:

Call on a call.

Call on a put.

Put on a call.

Put on a put.

There will be two sets of strikes and

maturities. The first set, K1 and T1,
are the strike and time at which you
can exercise the option on the
option, and K2 and T2 are the strike
and time at which you can exercise
the option on the underlying.

We can also be long or short any of

these options, so there are really a
total of 8 potential positions.
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Compound Option

Call on a call: you have the right at time

T1 to pay K1 for an option that will allow
you to buy the underlying stock at time
T2 at price K2.

Call on a put: you have the right at time

T1 to pay K1 for an option that will allow
you to sell the underlying stock at time
T2 for price K2.

Put on a call: you have the right at time

T1 to sell for price K1 an option that will
allow you to take a short position in a call
on the stock at strike K2 and with
maturity T2.

Put on a call: you have the right at time

T1 to sell for price K1 an option that will
allow you to take a short position in a put
on the stock at strike K2 and with
maturity T2.
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Compound Option
There are closed form solutions
available for these options. For
example, the value of a European
Call on a Call is:

M is the cumulative bivariate normal

distribution. S* is the asset price at time
T1 for which the option price at time T1
equals K1.
( ) ( )
2 2 1
0 1 1 1 2 2 2 2 1 2 1 2
2
0
1 *
1 2 1 1
1
2
0
1
2
1 2 1 2
2
, ; / , ; / ( )
ln
2
, and a
ln
2
, and b
qT rT rT
call
c S e M a b T T K e M a b T T e K N a
where
S
r q T
S
a a T
T
S
r q T
K
b b T
T

_
_
+ +

,
,

_ _
+ +

, ,

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Compound Option

A call on a call with the binomial

model

Additionally, the binomial has the

advantage of being relatively easy to
implement and does not require the
bivariate binomial distribution.

Lets go back to the base case we have

been working. We have a stock with
S0=20, r=.05, =.30. Lets assume that
the option on which the option will be
written is a call with strike of $20 which
expires at time T2=6 months. Lets
further assume that we have a call on
that call that expires in three months,
and that its strike is $2. Both options are
European.

Thus, S0=20, K1=2, T1=.25, K2=20, and

T2=.50

Option on the underlying would be

worth $1.86 at time 0, but that the
option on the option would be worth
$0.69.
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Chooser Option

A chooser option is frequently referred to as an as you like it

option.

This option gives you the right to declare at time T1

whether the option is a put or a call with maturity at time
T2.

At time T1 the option value is the max(c,p).

We can use put-call parity to determine a valuation

formula if the chooser option is based on European
options and they have the same maturity and strike
price.

Lets redefine the T1 value as:

( )
( )
2 1 2 1
2 1 2 1
2
( ) ( )
1
( ) ( )( )
1
2
- (
max( , ) max ,
max 0,
thus it is equivalent to a package (i.e. portfolio) consisting of:
1. Call with strike price K and maturity T , and
2.
r T T q T T
q T T r q T T
q T
c p c c Ke S e
c e Ke S
e

+
+
1 2 1
) -( - )( )
1
put options with strike price and matu rity T .
T r q T T
Ke

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Chooser Option

Lets assume that we have a three

month chooser option on a stock
currently priced at 20, with =.30,
T2-T1=.25, and with K=20, and
r=.05, and q=0.

From Black-Scholes, the value of a call

with strike K and maturity T2=.50, (and
the above parameters) is: 1.93.

The number of put options to buy is

e0(.25)=1.

The strike for the put is 20e-(.05)

(.25)=19.75.

The Black-Scholes value for the put,

therefore is: $0.95.

Thus, the total value of the chooser is

1.93+(1)0.95 = 2.88.
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Lookback Option
A Lookback option is one in which
the payout is a function of both the
terminal stock value and the
maximum or minimum value the
stock achieves during the life of the
option.

For a European-style lookback call, the

payoff is the greater of zero or the
difference between the final asset price
and the minimum value of the asset
during the life of the instrument:
clookback=max(0,ST-Sminimum)

For a European-style lookback put, the

payoff is the greater of zero or the
difference between the maximum value
the asset reaches during the life of the
option and the final asset price.
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Lookback Option

There are valuation formulas for

lookbacks.

Note that Smin is the minimum price

achieved at the time of valuation at
time t=0, then Smin=S0.
( ) ( )
1
2 2
0 1 0 1 min 2 3
2
0 min
1
2 1
2
0 min
3
2
0 min
1
2
( ) ( ) ( ) ( )
2 1 2
where
ln( / ) ( / 2)
a
ln( / ) ( / 2)
2( / 2) ln( / )
Y qT qT rT
lookback
c S e N a S e N a S e N a e N a
r r q
S S r q T
T
a a T
S S r q T
a
T
r q S S
Y

_




,
+ +

+ + +

4/17/12
Lookback Option

Example: A stock is priced at $50,

with a volatility of 40%, and a
dividend yield of 0. The risk free rate
is 10%. How much is a Lookback call
on this stock worth?

$8.04

What if the option had originally

been a 6 month option, and the
lowest value the stock had reached
to date were $45, what would the
Lookback call be worth today (again
it still has three months to maturity)?

$9.04.

Essentially in a lookback option, the

strike price is set to be the
appropriate extreme observed over
the life of the option.
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Shout Option

A shout option is one in which the

long party can shout at the short
party one time during the life of the
option, which sets a sort of lower
payoff level.

At maturity, the holder receives

either the intrinsic value at the time
of the shout, or the payoff to a usual
European call/put (depending upon
the type of option that it is.)

Assume that you shout at time tau,

then your payout at maturity would
be (for a call):

Essentially a shout allows you lock

in a payout without forcing you to
give up your ability to earn a higher
payout if the price increases.
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Shout Option

Consider if we had a shout option

with 6 months to maturity. The stock
price is $20, and the strike is $22.
Lets say that after 1 month the
stock price had risen to $30. You
could shout at that point and you
would guarantee that you would earn
at least (30-22)=$8 at maturity.

If subsequently the stock price fell to

$28 at maturity, you would still earn
a payout based on your shouted
stock price of $30, so you would get
$8.

If, however, the stock price rose to

finish at $40, you would receive (40-
22) = $18.

Shout options are very similar to

American options, and they are
normally valued through a lattice
type arrangement.
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Basket Option

A basket option is similar to a

standard option, except that the
payout is based on the values of a
combination of assets, rather than a
single asset.

They can be structured in any way.

For example, you could take the

weighted average of the oil price and
the gold price, and have an option
that pays out depending on the
weighted average of the two assets.
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Basket Option

Basket options are also common with

currencies.

For example, you could have a rupee

basket option that would payout
based on the value of the Rupee
against Dollars, Euros, Pounds, and
Yen.

The important point to remember

about basket options is that their
value not only depends on the levels
of each asset within the basket, but
also the correlations between each
asset within the basket.
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An exotic product could
have one or more of the
following features:

The payoff at maturity depends not

just on the value of the underlying
index at maturity, but at its value at
several times during the contract's
life (it could be anAsian
optiondepending on some average,
alookback optiondepending on the
maximum or minimum, a barrier
optionwhich ceases to exist if a
certain level is reached or not
reached by the underlying, adigital
option,peroni options,range
options, etc.)

It could depend on more than one

index (as in abasket
options,Himalaya options,Peroni
options, or othermountain range
options, outperformance options,
etc.)

There could be call ability and put

ability rights.

It could involve foreign exchange

rates in various ways, such as
aquantoor composite option.
4/17/12