Exotic option

A type of option that differs from common American or European options in terms of the underlying asset or the calculation of how or when the investor receives a certain payoff. These options are more complex than options that trade on an exchange, and generally trade over the counter.

Investopedia Says:
For example, one type of exotic option is known as a chooser option. This instrument allows an investor to choose whether the options is a put or call at a certain point during the option's life. Because this type of option can change over the holding period, it is apparent that this type of option would not be found on a regular exchange, which is why it is classified as an exotic option.

Other types of exotic options include: barrier options, Asian options, digital options and compound options, among others.

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Option contracts that are variations on simple puts and calls or are different products with optionality built into them. Exotic options are available in various asset classes on which options are available, but are mostly found in the foreign exchange market. A common example is the Barrier Option, which itself comes in various forms such as knock-in options and knock-out options (and reversed versions of both) that can be either single-barrier options or double-barrier options. What those terms refer to and what barrier options have in common are one or two trigger prices that, if touched, will cause an option with predetermined characteristics to be created (knock-in option) or will cause an existing option to cease to exist (knock-out option). A double-barrier option has barriers on either side of the exercise price (i.e., one trigger price is higher than the strike price and the other is lower), whereas a single-barrier option has one trigger price that may be higher or lower than the strike price. Barrier options, because they risk either not being knocked in, or being knocked out, are cheaper than ordinary puts and calls, and a double knockout option is cheaper than a single knockout option.

Other examples of exotic options: basket options, which give the owner the right to receive two or more designated foreign currencies in exchange for a base currency, either at a prearranged rate of exchange or at the prevailing spot market rate; compound options, which are options on options, whereby the holder has the right to purchase another option at a pre-set date, at a pre-set option premium (a put on a call or a call on a put or a put on a put or a call on a call), and are used by corporations to hedge the foreign exchange risk of an uncertain acquisition or by speculators to bet on the volatility of volatility; Bermuda options, which combine the attributes of an American-Style Option and a European-Style Exercise; all-or-nothing options that pay out a set amount if the underlying asset price is above or below the exercise price at the time of expiration; best-of- two options that pay off based on the independent performances of two different securities or indexes, or better-of-two options that pay off on the better performing of two underlying assets or indexes; and others. See also Asian Options; Ladder Options; Lookback Options.

In finance, an exotic option is a derivative which has features making it more complex than commonly traded products (vanilla options). These products are usually traded over-the-counter (OTC), or are embedded in structured notes.

Consider an equity index. A straight call or put, either American or European would be considered non-exotic (vanilla). An exotic product could have one or more of the following features:

• The payoff at maturity depends not just on the value of the underlying index at maturity, but at its value at several times during the contract's life (it could be an Asian option depending on some average, a lookback option depending on the maximum or minimum, a barrier option which ceases to exist if a certain level is reached or not reached by the underlying, a digital option, peroni options, range options, etc.)
• It could depend on more than one index (as in a basket options, Himalaya options, Peroni options, or other mountain range options, outperformance options, etc.)
• 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.

Examples

• Barrier
• CPPI
• Cliquet
• Compound option
• Lookback
• Variance swap
• Peroni Options
• Unit Contingent Options
• Rainbow option
• Digital/Binary option
• Bermudan options

Further reading

• Haug, Espen Gaarder (2007). The Complete Guide to Option Pricing Formulas. New York: McGraw-Hill. ISBN 0-07-147734-9. 
• Banks, Erik; Paul Siegel (2007). The Options Applications Handbook: Hedging and Speculating Techniques for Professional Investors. New York: Wiley. ISBN 0-07-145315-6. 
• Kyprianou, Andreas E.; Wim Schoutens, Paul Wilmott (2005). Exotic Option Pricing and Advanced Levy Models. Hoboken, NJ: John Wiley & Sons. ISBN 0-470-01684-1. 
• Rebonato, Riccardo (1998). 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

• How Binary Options Work at Financial-edu.com
• Online Exotic Option Calculators:Asian, Barrier, Binary, Chooser, ... , sitmo.com
• Global Derivatives Options Database
• Option Valuation and Calculators, DerivativeOne.com Derivatives Valuation
• Exotic option equations, the Quant Equation Archive at sitmo.com

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