0% found this document useful (0 votes)
7 views

FD Few 9 Lecture

Uploaded by

relow81331
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
0% found this document useful (0 votes)
7 views

FD Few 9 Lecture

Uploaded by

relow81331
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 22

Financial Derivatives and

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

• Payoff depends on the average price of


underlying during option’s life
• May be average price or average strike
• Average Strike - average price of asset during
option’s life is strike price in payoff
• Average Price - average price of asset during
option’s life is asset price in payoff
Asian Option Payoffs

Option Type Payoff


Average price call max(SAVE – K, 0)
Average price put max(K - SAVE, 0)
Average strike call max(ST - SAVE , 0)
Average strike put max(SAVE - ST , 0)
Solving the Currency Hedging Problem

• Monthly Inflow = €100m


• Costs denominated in $
• xi = $ price of €1 in month i
• End of year converted amount ($) =
12
€100m x  xi e r (12  i ) / 12
i 1
Solving the Currency Hedging Problem

• We are trying to hedge:

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

• Per Euro payoff:

 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

• Similar to American-style options


• But exercise restricted to particular dates or
designated period
• Strike price may vary during option’s life
• Key benefit is they are OTC contracts made-to-
measure
Barrier Options

• Exist or desist if an agreed barrier is reached


• May be:
(a) Knock-Out
(b) Knock-In
(c) Rebate
• Up or Down!
A Barrier Option Example

S0 = 100,S1 = 80, Barrier = 75


• Stock price hits barrier during life of option
K = 95
• Down-and-in put pays 95 – 80 = 15 at maturity
• Down-and-out options are worthless
• 95 strike down-and-in call knocks in but worthless as
ST<K
• Barrier options can have a negative vega
Chooser Options

• After a specified time period long position


‘chooses’ put or call
• Determined by max(c,p)
• Decision can be complicated by different
categories, strikes and maturities
Lookback Options

• Payoff determined by the minimum or


maximum asset price during option’s life
• Call allows purchase of asset for lowest trading
price during period
• Put allows sale of asset for highest trading
price during period
Compound Options

• An option on an option hence 2 strikes and 2


maturity dates
• Value of compound call = max(c – X, 0)
• Value of underlying = max(ST – K, 0)
• To be exercised the stock price must exceed the
critical price
Compound Options

• To hedge currency to be received in the future


• Buy a call on an ATM put
• If foreign currency appreciates allow option to
expire
• If foreign currency depreciates acquire an ITM
put for the price of an ATM put
Gap Options

• Call option payoff is max(ST – K, 0)


• Range of ST where option pays off = (ST > K)
• Magnitude of payoff = (ST – K)
• Gap option separates the two
• E.g. option pays off S – 90 when S > 100
• 100 determines range, 90 determines
magnitude
Gap Call
GAP CALL

Payoff

60

10

0 50 100 150

Stock Price
Gap Put
Payoff

40

-10
50 100 150
Stock Price

Pays off 90 – S when S < 100


Gap Options

• May require holder to pay out on expiration!


• E.g. gap put pays off 90 – S when S < 100
• ST = 95, ST < 100, Payoff = 90 – 95 = -5
• This is an obligation
• Hence term ‘option’ is misleading
Other Exotic Options
• Exchange Options – pays off if underlying asset
outperforms a benchmark
• Shout Options – holder has opportunity to contact
writer at any one time during option’s life. Provides
an alternative payoff to that on exercise date
• All-or-Nothing Options – pays off a fixed amount or
zero contingent on some event
• Rainbow Options – options on a basket of underlying
securities
Conclusion

• Vast array of exotic options


• Facilitate a wide range of hedging and
investment opportunities
• Traded in OTC markets
• Pricing is highly complex

You might also like