In finance, an exotic option is an option which has features making it more complex
than commonly traded vanilla options. Like the more general exotic derivatives they may
have several triggers relating to determination of payoff. An exotic option may also include
non-standard underlying instrument, developed for a particular client or for a particular
market. Exotic options are more complex than options that trade on an exchange, and are
generally traded over the counter.
Etymology The term "exotic option" was popularized by
Mark Rubinstein's 1990 working paper "Exotic Options", with the term based either on exotic
wagers in horse racing, or due to the use of international terms such as "Asian option",
suggesting the "exotic Orient". Journalist Brian Palmer used the "successful
$1 bet on the superfecta" in the 2010 Kentucky Derby that "paid a whopping $101,284.60" as
an example of the controversial high-risk, high-payout exotic bets that were observed
by track-watchers since the 1970s in his article about why we use the term exotic for certain
types of financial instrument. Palmer compared these horse racing bets to the controversial
emerging exotic financial instruments that concerned then-chairman of the Federal Reserve
Paul Volcker in 1980. He argued that just as the exotic wagers survived the media controversy
so will the exotic options In 1987, Bankers Trust Mark Standish and David
Spaughton, were in Tokyo on business when "they developed the first commercially used
pricing formula for options linked to the average price of crude oil." They called this
exotic option, the Asian option, because they were in Asia.
Development Exotic options are often created by financial
engineers and rely on complex models to price them.
Features A straight call or put option, either American
or European, would be considered non-exotic or vanilla option. There is no strict definition
of what is considered an exotic option but it could have one or more of the following
features: The payoff at maturity depends not just on
the value of the underlying instrument at maturity, but at its value at several times
during the contract's life It could depend on more than one index such
as in basket options, outperformance options, Himalaya options, peroni options, or other
mountain range options The manner of settlement may vary depending
on the moneyness of the option at expiry, such as a cash or share option.
There could be callability and putability rights.
It could involve foreign exchange rates in various ways, such as a quanto or composite
option. Even products traded actively in the market
can have the characteristics of exotic options, such as convertible bonds, whose valuation
can depend on the price and volatility of the underlying equity, the credit rating,
the level and volatility of interest rates, and the correlations between these factors.
Barriers Barriers in exotic option are determined by
the underlying price and ability of the stock to be active or inactive during the trade
period, for instance up-and –out option has a high chance of being inactive should
the underlying price go beyond the marked barrier. Down-and-in-option is very likely
to be active should the underlying prices of the stock go below the marked barrier.
Up-and-in option is very likely to be active should the underlying price go beyond the
marked barrier. Examples
References
Further reading Haug, Espen Gaarder. The Complete Guide to
Option Pricing Formulas. New York: McGraw-Hill. ISBN 0-07-147734-9.
Banks, Erik; Paul Siegel. The Options Applications Handbook: Hedging and Speculating Techniques
for Professional Investors. New York: Wiley. ISBN 0-07-145315-6.
Kuznetsov, Alex. The Complete Guide to Capital Markets for Quantitative Professionals. New
York: McGraw-Hill. ISBN 0-07-146829-3. Kyprianou, Andreas E.; Wim Schoutens; Paul
Wilmott. Exotic Option Pricing and Advanced Levy Models. Hoboken, NJ: John Wiley & Sons.
ISBN 0-470-01684-1. Rebonato, Riccardo. Interest-rate Option Models:
Understanding, Analysing and Using Models for Exotic Interest-rate Options. New York:
McGraw-Hill. ISBN 0-471-97958-9. External links
A paper on exotic options Overview of exotic options