FD Few 9 Lecture
FD Few 9 Lecture
Financial Engineering
Week 9
Exotic Options and
Applications in Financial
Engineering
Learning Outcomes
By completion of this topic you should understand the features and
financial engineering applications of the following options:
• Asian
• Bermudan
• Barrier
• Chooser
• Lookback
• Compound
• Gap
• Exchange
• Shout
• All-or-nothing
• Rainbow
What are Exotic Options?
• Non-standard options
• Precise, customised methods of dealing with
risk exposure and strategy construction
• Traded OTC
• Suggested benefits:
– Avoid regulation
– Often cheaper than PV options
– Exploit expectations
– Manage risks
Hedging a Currency Stream
• US company has large Euro inflows
• Exposed to exchange rate fluctuations
• Go long in Euro put?
• What if Euros are a flow?
• Requires a series of puts
• BUT, an expensive way to hedge an average
exchange rate!!!
Asian Options
12 12 x
i x 12 x i 1 i
12
i 1
• We could use an option on the average i.e. an
Asian option
• An average price Asian put can impose a floor,
K, on average exchange rate received
Solving the Currency Hedging Problem
1 12
max K xi ,0
12
i 1
• E.g. to guarantee average exchange rate of
$0.90 per €, set K = $0.9
• Need to buy enough options to cover €1.2bn
Bermudan Options
Payoff
60
10
0 50 100 150
Stock Price
Gap Put
Payoff
40
-10
50 100 150
Stock Price