05-12-2020

Exotic Options

Sankarshan Basu
Professor of Finance
Indian Institute of Management
Bangalore

What are Exotic Options?

• Exotic options or simply exotics are non-
standard products traded in the OTC
markets.
• These products are generally much more
profitable than plain vanilla products to
investment banks.
• Harder to price, sometimes being very model
dependent.
• Inherent risks are usually more obscure and can
lead to unexpected losses.

Packages
• Portfolios of standard options along with
stock itself.
• Examples:
– Bull spreads, bear spreads, straddles, etc.
• Often structured to have zero cost.
• One popular package is a range
forward contract (long call + short
put or short call +long put).

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Packages – Range Forward Contract

• A short-range forward contract consists of a long
position in a put with a low strike price, K1, and a short
position in a call with a high strike price, K2.
– It guarantees that the underlying asset can be sold for a price
between K1, and K2 at the maturity of the options.

• A long-range forward contract consists of a short

position in a put with the low strike price, K1, and a long
position in a call with the high strike price, K2.
– It guarantees that the underlying asset can be purchased for a
price between K1, and K2 at the maturity of the options.

• The price of the call equals the price of the put when the
contract is initiated.

Perpetual American Calls and Puts

• A perpetual American option is a contract
without an expiry date. It can be exercised
at any time.
• They can be preferable to standard options
because they eliminate the expiration risk.
• To price this option, it is important to
determine the optimal exercise boundary
(and the optimal stopping time).

Non-Standard American Options

• Exercisable only on specific dates (Bermudan
option)

• Early exercise allowed during only part of life

(initial “lock out” period with no early exercise)

• Strike price changes over the life (warrants,

convertibles)

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Forward Start Option

• A forward start option is an exotic option that is
purchased and paid for now but becomes active later
with a strike price determined at that time. The
activation date, expiration date, and underlying asset
are fixed at the time of purchase.
• It is similar to a vanilla option, except the forward start
option doesn't activate until sometime in the future and
the strike price is unknown when the option is bought.
The strike price is unknown at initiation but is typically
set to be at- or near-the-money when the option
activates.
• Most common is employee stock option plan.

Compound Options
• Compound options are options on options.
• Examples: Call on call, Call on put and Put on call,
Put on put
• Compound options would be useful if an investor
thought he might need an option later and wanted to
establish a price at which the option could be bought
or sold.
• Price is quite low compared to a regular option.
• Compound options have two strike prices and two
exercise dates.
• It is more common to see compound options in
currency or fixed-income markets, where an
uncertainty exists regarding the option's risk
protection capabilities.

Compound Option - Example

• A major contracting company is tendering for the
contract to build two hotels in one month time. If
they win this contract in 1 month they would need
financing for USD 20 million for 3 years. The
calculation used in the tender utilizes today's interest
rates. The company, therefore, has exposure to an
interest rate rise over the next month. They could buy
a 3-yr interest rate cap starting in one month but this
would prove to be very expensive, if they lost the
tender.
• The alternative is to buy a one month call option on a
3-yr interest cap. If they win the tender, they can
exercise the option and enter into the interest rate
cap at the predetermined premium. If they lose the
tender, they can let the option lapse. The advantage is
that the premium will be significantly lower.

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Chooser Option
• Also referred to as “As You Like It” option.
• Option starts at time 0, matures at T2
• At T1 (0 < T1 < T2) buyer chooses whether it is a put
or call option.
• Suppose that the time when the choice is made is
T1. The value of the chooser option at this time is
Max (c, p)
where c is the value of the call underlying the
option and p, the value of the put underlying the
option.

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Barrier Options
• Option comes into existence only if stock price hits
barrier before option maturity - ‘Knock-In’ options
• Option dies if stock price hits barrier before option
maturity - ‘Knock-Out’ options
• ‘Up’ options - Stock price must hit barrier from below,
i.e., barrier level is higher than current asset price.
• ‘Down’ options - Stock price must hit barrier from above,
i.e., barrier level is below the initial asset price.
• Option may be a put or a call. Eight possible
combinations.

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Barrier Options
• A down and out call option is a regular call option that
ceases to exist if the asset price reaches a certain barrier
level H. The barrier level is below the initial asset price.
• A up and in put option is a put option that comes into
existence only if the barrier is reached.

• Barrier options have fewer positive payoffs than standard

European options. Hence, less expensive.
• Investors wanting to save part of premium money and
do not want to pay for outcomes they do not believe are
likely to occur will be attracted to barrier options.

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Barrier Option –
Up and Out Call Option

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Barrier Option –
Down and In Put Option

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Cliquet Option
• A series of forward start options is called a
cliquet or ratchet option. Each option becomes
active when the previous option in the series
expires and each strike also sets at the time of
activation.
• For example, a cliquet might consist of 20 at-the-
money three-month options. The total life would
then be five years
• When one option expires a new similar at-the-
money is comes into existence

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Gap Options
• Gap call pays ST − K2, when ST > K1
• Gap put pays off K2 − ST when ST < K1
• A type of binary options whose stated strike price is different
from its payoff strike. That is, there is a gap between the price
at which the option can be exercised and the price at which it
would produce a payoff to the holder. The strike price
determines the size of the option’s payoff, while a gap amount
determines whether the payoff would be made or not.
• For example, consider a gap call option where the underlying’s
price is 100, the stated strike price is 100, and the payoff strike
is 105. The option can be exercised when the underlying’s
price reaches or crosses 100. However, it pays nothing unless
the underlying reaches or crosses 105.
• The gap option is also known as a pay-later option.

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Basket Option
• A basket option is an option whose payoff is linked to a
portfolio or “basket” of underlying values. The basket can
be any weighted sum of underlying values so long as the
weights are all positive. Basket options are usually cash
settled.
• Basket options are popular for hedging foreign
exchange risk. A corporation with multiple currency
exposures can hedge the combined exposure less
expensively by purchasing a basket option than by
purchasing options on each currency individually.
• Basket options are often priced by treating the basket’s
value as a single underlying and applying
standard option pricing formulas.

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Basket Option - Example

• Suppose, a French company has export earnings 50% in
Canadian Dollar and 50% in US Dollar and worried about
Euro appreciating against these currencies in the next one
year. Assuming that the spot price of CAD is 0.64 Euro and
that of USD is 0.84 Euro. So, the weighted average value =
0.5*0.64+0.5*0.84 = 0.74 Euro. The company can then buy
one-year OTC basket put option of these two currencies at a
strike price of say, 0.74 Euro.
• If the two currencies appreciate in one year and the index
value stands at 0.78, the put option expires worthless. The
Euro has depreciated and the company will be better off
selling the export earnings in spot market.
• If the two currencies depreciate in one year and the index
value stands at 0.72, the company can exercise the put option
and ensure the minimum realization of export earnings at the
strike price of 0.74 Euro.

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Binary (Digital) Options

• Cash-or-nothing call: pays Q if ST > K,
otherwise pays nothing.
• Cash-or-nothing put: pays Q if ST < K,
otherwise pays nothing.

• Asset-or-nothing call: pays ST if ST > K,

otherwise pays nothing.
• Asset-or-nothing put: pays ST if ST < K,
otherwise pays nothing.

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Binary (Digital) Option - Example

• A trader thinks the Reliance Industries stock will touch
Rs 2,400 in a month's time. Through a broker, who
deals in binary options, he buys a 'cash or nothing'
binary call option of RIL with fixed binary payoff of Rs
1,000. Now, he buys call option at strike price of Rs
2,400, which will expire in one month. Now on the
expiry date, RIL shares close at Rs 2,455, which means
the option expires 'in the money'. So the trader will
receive Rs 1,000 and his net profit will be Rs. 1,000 less
the option premium. Had the stock closed below Rs
2,400, the option holder would have received no money
as the option is out of money and the loss will be the
option premium paid up front.

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Lookback Options
• A lookback call allows you to buy the asset at the
lowest price and the Lookback put allows you to
sell the asset at the highest price.
• Since you never have to miss in timing the
market, a lookback option is also called a “no-
regrets option”.
• The payoffs from lookback options depend on
the maximum or minimum asset price reached
during the life of the option.

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Lookback Options
• Floating lookback call pays max (0, ST – Smin) at time T,
allowing the buyer to buy asset at the lowest observed
price.
• Floating lookback put pays max (0, Smax– ST) at time T,
allowing the buyer to sell asset at highest observed price.

• In fixed lookback options, a strike price, K is specified.

• Fixed lookback call pays max (0, Smax – K) at time T.
• Fixed lookback put pays max (0, K – Smin) at time T.

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Shout Option
• Buyer can ‘shout’ during the option life.
• Final payoff is either
– Usual option payoff, max(ST – K, 0), or
– Intrinsic value at time of shout, St – K
• Shout options allow one, or multiple points, where
the holder can lock in gains.
• For a call shout option, if the strike price is $50 and
the underlying asset trades to $60 before expiration,
the holder may "shout," or lock in the $10 the option
is trading in the money (ITM).
• With multiple shouts, the holder still keeps the call
option and can make an additional profit if the
underlying moves even higher before expiration.

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Asian Options
• An Asian Option is an option in which either the final
asset price or the exercise price is replaced by the average
price of the asset over the option’s life or over a specified
period of time.
• Payoff related to average stock price.
• Average Price options:
– Call: max(Save – K, 0)
– Put: max(K – Save , 0)
• Average Strike options:
– Call: max(ST – Save , 0)
– Put: max(Save – ST , 0)

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Seagull
• A seagull option is a type of investment strategy that is
sometimes used in currency trading.
• A bullish currency trader can set up a long seagull. It is
set up by purchasing a call spread (two calls), financed by
the sale of one out of the money put, ideally to create a
zero premium structure. The payoff diagram will appear
as follows.

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Seagull
• A bearish currency trader can set up a short seagull. It is set
up by purchasing a put spread (two puts), financed by the sale
of one out of the money call, ideally to create a zero premium
structure. The payoff diagram will appear as follows.

• So, the process involves using a combination of purchases and

sales on the currency options involved in an attempt to keep
the risk level of the investment within reasonable level. In
addition to minimizing risk, the use of a seagull option is
relatively inexpensive.

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Volatility and Variance Swaps

• A volatility swap is an agreement to exchange
the realized volatility of an asset between time 0
and T for a prespecified fixed volatility. Payoff =
Notional Principal*(σrealized - σfixed ). Basically,
trading on volatility.
• A variance swap is an agreement to exchange
the realized variance rate of an asset between
time 0 and T for a prespecified fixed variance
rate. Payoff = N Principal*(Varrealized - Varfixed ).

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