What are Exotic Options?
Exotic options are either variations on the payoff profiles of the vanilla options or they are wholly different kinds of products with optionality embedded in them. The exotic options market is most developed in the foreign exchange market.
Types of Exotic Options
The first example of exotic options, a barrier option is like a plain vanilla option but with one exception: the presence of one or two trigger prices. If the trigger price is touched at any time before maturity, it causes an option with pre-determined characteristics to come into existence (in the case of a knock-in option) or it will cause an existing option to cease to exist (in the case of a knock-out option).
There are single-barrier options and double-barrier options. A double-barrier option has barriers on either side of the strike (i.e. one trigger price is greater than the strike and the other trigger price is less than the strike). A single-barrier option has one barrier that may be either greater than or less than the strike price. Why would we ever buy an option with a barrier on it? Because it is cheaper than buying the vanilla option and we have a specific view about the path that spot will take over the lifetime of the structure.
Intuitively, barrier options should be cheaper than their vanilla counterparts because they risk either not being knocked in or being knocked out. A double knockout option is cheaper than a single knockout option because the double knockout has two trigger prices, either of which could knock the option out of existence. How much cheaper a barrier option is compared to the vanilla option depends on the location of the trigger.
Barrier Options and Volatility
For a given trigger, we should note that we would expect the difference in price between the vanilla price and the knockout price to increase with moves higher in implied volatility. A higher implied volatility means that spot is more likely to trade at the trigger than if spot were less volatile. A greater likelihood of trading at the trigger means a greater likelihood of getting knocked out. The opposite applies to knock-in options.
Now, turn to the case where the barrier is in-the-money with respect to the strike. A knock-out option in which the barrier is in-the-money with respect to the strike is called a reverse knock-out option. A knock-in option in which the barrier is in-the-money with respect to the strike is called a reverse knock-in option.
How do we make money with this position? For example, we would buy a cheap 1-month 1.10 US dollar call/Canadian dollar put that knocks out at 1.16 if we believe that spot will be contained within a narrow range around the current spot. Ideally, spot drifts higher very slowly, ending up just less than 1.56 at expiry (say at 1.1580) without ever trading at that level. We exercise the option, buying our US dollars against Canadian dollars at 1.10 and sell them simultaneously in the spot market, locking in 0.0580 Canadian dollar cents/US dollar notional. The higher the implied volatility at the time the option is priced, the cheaper the knock out option with the in-the-money trigger will be, compared to the similar plain vanilla option.
Higher implied volatilities suggest a greater probability of triggering the barrier and knocking out the exotic options. The reverse is true of the reverse knock-in option. It will still be cheaper than the plain vanilla option, but not by very much. The higher the implied volatility, the less of a difference there will be in price between the reverse knock-in option and the corresponding plain vanilla option. If we own a reverse knock-out option and a reverse knock-in option with the same maturity, strike, and trigger, holding the combined position is equivalent to owning the corresponding plain vanilla option.
Barrier Option Management
Managing reverse barrier exotic options can be a difficult proposition, especially if spot trades near the barrier as it gets close to maturity. A double-barrier option is like a more complicated version of a reverse barrier option. The term “Asian options,” contrary to what one might think on the face of it, refers to options whose payoff is contingent upon the path that spot takes over the lifetime of the option; the payoff depends on the path that the spot took over the life of the option.
The payoff of average rate options is calculated by taking the difference between the average for a pre-set index over the life of the option and the strike price and then multiplying this difference by the notional amount. Because an average of a spot price is less volatile than a spot price, average rate options are naturally cheaper than the corresponding vanilla options.
A lookback call gives the owner the right to buy the underlying at expiry at a strike price equal to the lowest price that spot traded over the life of the option. A lookback put gives the owner the right to sell the underlying at expiry at a strike price equal to the highest price that spot traded over the life of the option. The payoff of lookback options depends on the best rate that spot traded over the life of the option.
Lookbacks are expensive. Anything that gives you the right to pick the top or the bottom is going to be costly. As a general rule of thumb, some people like to think that lookback prices are in the ballpark if they are roughly twice the price of an at-the-money straddle.
A second example of exotic options, a compound option is an “option-on-an-option.” As an example, it could be a “call-on-a-call” giving the owner the right to buy, in 1 month’s time, a 6 month 1.15 US dollar call/Canadian dollar put expiring 7 months from today. The strike price on the compound is the premium that we would pay in 1 month’s time if we exercised the compound for the option expiring 6 months from that point in time. These types of products are often used by corporations to hedge the foreign exchange risk involved with overseas acquisitions when the success of the acquisition itself is uncertain. Sophisticated speculators use compound options to speculate on the volatility of volatility.
Exotic Options Overview
Generally speaking, exotic options are simply more complicated and complex than vanilla options. While their uses and characteristics are more-or-less the same as most options, they also have secondary characteristics, such as callability and puttability,that can change their role in a derivatives portfolio.