EXOTICS

DERIVATIVES
 SYNTHETIC FINANCIAL
INSTRUMENTS
Synthetic financial instruments are artificially created
investment vehicles or instruments intended to meet
requirements not met by existing, conventional instruments.
They are designed to reduce risk, increase diversification or
offer a higher return. A synthetic floating rate instrument can
be produced by combining a fixed-rate bond and an interest
rate swap. Or an asset with the same risks and rewards as the
underlying share can be created by the purchase of a call
option and the simultaneous sale of a put option on the same
share.
FUTURE OPTIONS

A futures option, or option on futures, is an option

contract in which the underlying is a single futures
contract. The buyer of a futures option contract has
the right (but not the obligation) to assume a
particular futures position at a specified price (the
strike price) any time before the option expires.
 CASH AND CARRY & REVERSE CASH AND
CARRY ARBITRAGE

If the futures/option price is greater than 𝑆𝑡(1+ r), then an

arbitrageur can profit by engaging in a cash and carry strategy.
This would entail borrowing $ 𝑆𝑡 and buying the stock in the spot
market and simultaneously going short in the futures market to
sell the asset at a future date for a price of 𝐹𝑡. This is cash and
carry arbitrage.
CONT.

 
• On the other hand, if < (1+r), then a reverse cash and carry
arbitrage is possible.
• This is possible through short selling the stock and lending out
the proceeds and simultaneously going long in a futures
contract to acquire the asset subsequently going long in a
futures contract to reacquire the asset subsequently at a price ,
in order to cover the short position.
 FOREIGN EXCHANGE FUTURES.
A transferable futures contract that specifies the price at which a currency can
be bought or sold at a future date. Currency future contracts allow investors to
hedge against foreign exchange risk.

Because currency futures contracts are marked-to-market daily, investors can

exit their obligation to buy or sell the currency prior to the contract's delivery
date. This is done by closing out the position. With currency futures, the price
is determined when the contract is signed, just as it is in the forex market, only
and the currency pair is exchanged on the delivery date, which is usually some
time in the distant future. However, most participants in the futures markets
are speculators who usually close out their positions before the date of
settlement, so most contracts do not tend to last until the date of delivery.
 INTEREST RATE OPTIONS

Interest rate options give buyers the right, but not the

obligation, to pay (in the case of a cap) or receive (in the

case of a floor) a predetermined interest rate (the strike

price) over an agreed period.

CAP
An interest rate cap is actually a series of European interest

call options (called caplets), with a particular interest rate. It

is a derivative in which the buyer receives payments at the

end of each period in which the interest rate exceeds the

agreed strike price. An example of a cap would be an

agreement to receive a payment for each month the LIBOR

rate exceeds 2.0%.

FLOORS:

An interest rate floor are similar to caps in that they consist

of a series of European interest put options (called caplets)

with a particular interest rate. It is a derivative contract in

which the buyer receives payments at the end of each period

in which the interest rate is below the agreed strike price.

 COLLARS

An interest rate collar is a combination of a cap and a

floor in which the buyer buys a cap and simultaneously

sells a floor. So collar specify both the upper and lower

limits for the rate that will be charged.

 EXAMPLE

Eg: Suppose that a firm holds a fixed rate assets which are yielding10%. These
assets are financed through floating rate liabilities tied to LIBOR., assuming
current rate at 8%. Suppose that the firm wants to cap the cost at 9.0% (buying
a cap at 0.5%) then it has to pay upfront premium, assuming 0.5 % p.a. If the
firm feels that this premium is too high to pay, but, as it happens, the firm finds
that it can sell a prime floor with a floor rate at 7% for a premium at 0.5% p.a.

From the firm’s perspective, its annual costs are now bounded between 7% to
9.0%. It means that when the prime rate rises above 9.0%, the dealers pays the
firm the difference. If the prime rate falls below 7%, the firm pays the difference
to the dealer.
 FORWARD START OPTION

The advance purchase of a put or call option with a

strike price that will be determined at a later date,
typically when the option becomes active. A forward
start option becomes active at a specified date in the
future; however, the premium is paid in advance, and
the time to expiration and the underlie are established at
the time the forward start option is purchased.
 COMPOUND OPTION

A compound option is an option on an option. That is, you can buy

an option that gives you the right (but not the obligation) to buy or
sell an underlying vanilla option at an agreed upon price on an
agreed date.

If on the expiry date of the compound option itself, you can buy or
sell the underlying option at a better rate in the market, you will
not exercise the underlying option. You only pay the premium for
the underlying option if you exercise it.
CONT.
A compound option can take four basic forms,
each of which you can buy or sell:
Call on a call
Call on a put
Put on a call
Put on a put
 WHY USE A COMPOUND OPTION?

A compound option can be used:

If the buyer is unsure about the need for hedging in a certain period. 
This is useful for companies bidding for a foreign contract when the outcome of the bid is
uncertain.

For example, a Japanese company has put in a bid to buy a foreign business for $10 million.
The result of the bid will only be known in two month's time; so for the next two months,
the company has exposure to changes in the USD/JPY spot. The company does not want to
buy a vanilla option as the premium is high and the outcome of the bid uncertain. A good
compromise is to buy a compound, as the premium is significantly lower and it provides
the benefit of a guaranteed price for the option on a date in the future.

It is possible to take a speculative position with minimal outlay (i.e., the premium of the
compound option itself) through CO.
 SWAPTION
A swaption is an option on a forward start swap which

provides the purchaser the right to either pay or receive a fixed

rate. A buyer of a swaption who has the right to pay fixed and

receive floating is said to have purchased a 'payers swaption'.

Alternatively, the right to exercise into a swap whereby the

buyer receives fixed and pays floating is known as a 'receivers

swaption'.
 BARRIER OPTIONS
These are such options where the pay off depends on whether the
underlying asset’s price reaches a certain level during a specified period of
time. It means the value of a barrier option depends on whether the asset’s
price crosses the underlying certain level or not.

The barrier options can be either;

Knock-out Option: Ceases to exist when the underlying asset price reaches
a certain barrier.

Or

Knock-in Option: Comes into existence only when the underlying asset
price reaches a barrier.
 LOOK BACK OPTION

An exotic option that allows investors to "look back" at

the underlying prices occurring over the life of the

option and then exercise based on the underlying asset's

optimal value. This type of option reduces uncertainties

associated with the timing of market entry. 

 ASIAN OPTIONS

An option whose payoff depends on the average price of the underlying asset over

a certain period of time as opposed to at maturity. Also known as an average value

option. 

(An Asian option (or average value option) is a special type of option contract. For

Asian options the payoff is determined by the average underlying price over some

pre-set period of time. This is different from the case of the usual European

option and American option, where the payoff of the option contract depends on

the price of the underlying instrument at exercise; Asian options are thus one of

the basic forms of exotic options.)

 RAINBOW OPTION
A rainbow option is a derivative whose value is dependent on two or more
underlying securities or events. An example of a rainbow option would be
an outperformance option which allows an investor to exchange one stock for
another. In this case, the investor's decision to exercise the option is dependent on the
price of both stocks.

For example: An option which allows a person to exchange 6 shares of Morgan

Stanley for 1 share of Goldman Sachs would be a rainbow option. The option holder
would gain if Morgan Stanley shares fall in value relative to Goldman shares, and lose
if they relatively increase.

Rainbow options are useful for hedging risks arising from several events. The price of
the rainbow option, to a large extent, is dependent on the correlation of the
underlying events or assets -- with lower correlation leading to higher prices.
 BASKET OPTION

A basket option is a financial derivative, more

specifically an exotic option, whose underlying is a
(weighted) sum or average of different assets that have
been grouped together in a basket. For example
an index options, where a number of stocks have been
grouped together in an index and the option is based on
the price of the index.