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FD Few 9 Lecture

Uploaded by

relow81331
Copyright
© © All Rights Reserved
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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

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