Hello, and welcome back to my Youtube channel where we learn all about derivatives and quantitative
finance.
Today we will learn about exotic options, things like compound options, chooser options,
gap options, barrier options lookback options, quantos and many more.
[MUSIC]
In todays class we are going to learn all about exotic options, so I guess the first
thing I should do is explain what an exotic option is.
Simple put and call options or combinations of them are called “vanilla” or plain
vanilla options.
These have standard properties and trade actively.
The alternatives to these are referred to as “exotic” options.
Typically these are over the counter derivatives and have various nonstandard features.
Exotics serve market niches including: specific hedging needs; tax, accounting, legal, or
regulatory needs; or offer investors unique payoffs in particular market circumstances
that are not easily accessible to Investors were these products not available.
Nonstandard features include: a hybrid of American- or European-style exercise capabilities;
alternative payoffs or payoffs that do not depend precisely on one strike price; fixed
payout options above a specified strike price; or those with a payoff based on the average
performance of the underlying over the option’s life.
If you would like to learn more about this topic, or derivatives in general, all of these
classes are based on my book, trading and pricing financial derivatives.
There is a link to the book provided in the description below.
Bermudan Options Bermudan options are a cross between American-
and European-style options.
They are named Bermudan options because Bermuda is physically between the U.S. and Europe.
These options can be exercised on certain dates during the life of the option, often
monthly.
Bermudan options offer the sellers more control over when an option can be exercised against
them, and therefore the contract is less expensive for the buyer than an American-style option,
but not as inexpensive as a European option (which only allows exercise at expiration).
These options can be priced using Binomial Trees where at particular nodes early exercise
is a possibility, and at other nodes it is not.
Forward Start Option Forward start options are options that start
at some point in the future; the exercise price is typically set at the current price
at the beginning of the option’s life.
Employee stock options are an example of a forward start option.
The other main purpose of trading them is to gain an exposure to forward volatility.
Forward start options can be valued with a modified version of the Black-Scholes model
Compound Options Compound options are options on options: A
call that enables you to buy another call, a put on a call, a call on a put, or a put
on a put.
The underlying asset of the first option is simply another option.
Compound options allow buyers to effectively implement their strategy with greater leverage
than one simple direct options position, and are cheaper at inception than a straight options
position for the full timeframe.
However because you make a second payment when you exercise the first option, the full
amount of premiums paid on the two options will be greater than the premium on one option
for the entire duration.
Chooser Options Chooser options allow the buyer, after a specified
time, to choose if the option is a call or a put.
This is particularly attractive if the underlying is expected to experience significant volatility,
and potentially in either direction.
This is riskier than a straddle strategy.
With a chooser option, you might choose the call after it has rallied, but by the time
expiry is approaching, the underlying may have fallen and you may end the contract out
of the money, whereas with a straddle, you have a “live” put and a “live” call
right up until maturity.
For this reason, chooser options are cheaper than straddles.
Barrier Options Barrier option payoffs depend on whether the
underlying hits a certain level, whichh we call the barrier, before the expiration date.
These options can either knock-in or knock-out.
A knock-in option has no intrinsic value until the underlying touches the barrier price,
at which point it becomes a vanilla option.
A knock-out option is like a vanilla option but if the underlying exceeds the barrier
price, it becomes worthless.
There are eight types of barrier options: they can be up and out, or down and out calls
or puts; or they can be down and in or up and in puts or calls.
Barrier options are path-dependent options because their value depends on the previous
prices of the underlying during the life of the option.
Barrier options are always cheaper than an otherwise similar option without a barrier.
As an example, if you were bullish on Facebook’s stock over the next 1 year timeframe, but
were confident that it would not exceed $250 per share over that period, you might be happy
to buy a one year up and out call option with a strike around the current price ($150 at
the time of writing this book) but a knock-out barrier at $250.
Hopefully you can see how this has some similarity to something like a call spread, but this
payoff is considerably worse [AD LIB] The Greeks on barrier options behave quite
differently than those of vanilla options.
If you compare an up-and-out call option with a vanilla call option.
As the stock price moves up, a vanilla call will increase in value, while an up-and-out
call is affected by two opposing forces.
As the stock price moves up, the up-and-out call's payoff becomes potentially larger just
like the vanilla call, but the upward move simultaneously threatens to destroy the value
of the contract by moving it closer to the knock out barrier.
This conflict makes the option value very sensitive to the stock's movement as it gets
close to the barrier, and delta can flip rapidly from positive to negative at these points
making these options very difficult to hedge.
Barrier option values can decrease with increasing volatility, unlike vanilla calls and puts.
The up-and-out call described above becomes more likely to get knocked out near the barrier
as volatility increases.
Even though the Investor is long volatility relative to the strike level, they are short
volatility relative to the barrier.
Binary Options, also Known as Digital Options Binary options are discontinuous payoff options.
An example would be a payoff of X if ST>K, otherwise 0.
So the owner of a binary call option would receive either a 0 payoff or a full, set payoff
amount if the underlying’s price is above a pre-set level K, but the payoff does not
rise if the underlying is well above the strike K, instead it is a fixed payoff of X (see
Figure 14.3).
These are difficult for dealers to hedge well, particularly when the underlying trades close
to the strike near maturity.
Gap Option A gap option is a type of barrier option where
the strike making the option exercisable differs from the strike used to calculate the payoff.
Gap call options payoff ST–K1 when ST is greater than K2.
A modified Black-Scholes formula can be used to price this style of option.
Lookback Options Lookback option payoffs depend on maximums
or minimums of underlying asset price points over the option’s life.
These are path-dependent options that allow the option owners to “buy at the low”
or “sell at the high” over the life of the option.
The life of the option being from the contract first being agreed upon through to the expiration
date.
There are two types of lookback options: floating-strike and fixed-strike.
For floating-strike lookback calls, the exercise price is the minimum stock price reached over
the life of the option.
For floating-strike lookback puts, the exercise price is the maximum stock price reached over
the life of the option.
For fixed-strike options, the strike is fixed as with a vanilla option but, for fixed-strike
lookback calls the owner gets to exercise at the point when the underlying asset price
is at its highest level over the life of the option.
For fixed-strike lookback puts, the owner gets to exercise at the underlying asset’s
lowest price over the life of the option.
While these options sound like you cannot lose with them, they are of course priced
in a rational market and are considerably more expensive than vanilla options.
Their high prices can be reduced by restricting the maximums and minimums used in calculating
the payoffs, and these restricted versions are known as partial lookback options.
Asian Options Asian option payoffs depend on the average
price of the underlying over the option’s life, or some part of the option’s life,
rather than the spot price of the underlying on the expiration date.
The average can be calculated as either a geometric or arithmetic average.
The primary advantage of Asian options is that they reduce the potential for singular
episodes of market manipulation or one-off unusual price moves to undermine your investment
thesis, which might have otherwise been accurate.
Because of the volatility-dampening effect of the averaging feature, these are also cheaper
than European or American options.
Asian options are very common in the commodities space, particularly in options on oil.
Rainbow Options Rainbow options are those where delivery at
maturity can be on a choice of a number of assets.
These are usually calls or puts on a best-of or worst-of a basket of Y underlying assets.
This is also considered a type of correlation trading because the prices of these options
are sensitive to the correlation among the basket’s constituents.
Often Monte Carlo methods are used to value rainbow options.
Basket Options Basket options have payoffs that depend on
the performance of a basket of assets such as a set of individual stocks or indices,
or a group of currencies.
Typically the owner of a basket option has the right, but not the obligation, to buy
or sell a basket of underlying assets at maturity.
These are commonly used for currency hedging in institutions with varied currency exposures,
and often end up being cheaper than individual options purchased on each currency.
Quantos Quantity-adjusting options or quantos are
derivatives where the underlying is denominated in a currency other than that in which the
option is settled.
A quanto has an embedded currency forward with a variable notional amount.
They are attractive to investors who wish to have exposure to a foreign asset, but without
the corresponding foreign exchange risk.
These are used when investors expect the underlying foreign asset to perform well but do not expect
that the foreign country’s currency will perform well over the same timeframe.
Quanto futures, quanto options, and quanto swaps are available.
Well that is it for this video, there is a bit more covered in the book whichh I have
linked to below.
The rules of youtube state that if you make it all the way to the end of one of my videos,
you are required to hit the like button.
If you want to see more videos like this, click the subscribe button.
If you want to be notified whenever I upload a new video hit the bell button next to the
subscribe button.
Have a great day, and thanks for watching.