Exotic Options BA Financial Markets and Institutions Chavanun Yainuknaen (SEA) Spring 2013

Outline Put and call options Exercise styles FLEX options Exotic options Market and exotic options 1

What is Option? A financial derivative that represents a contract sold by a writer(seller) to a holder(buyer) Grants the buyer the right, but not the obligation, to call or put a security or other underlying assets at the strike price during a certain period of time or on an exercise date Option premium : The price paid to acquire the option The expiration date or maturity date : The last day that an options is valid 2

Types of Option  Call option The right to “buy”  Put option The right to “sell” 3

Status of Call and Put Options Call Option Put Option In the money Out of the money At the money Strike Price Out of the money Asset Price 4

Exercise Styles Plain options (Vanilla options) American options European options Exotic options Bermuda options Binary options Barrier options Lookback options Asian options Shout options Outperformance options Etc. 5

Flexible Exchange Options (FLEX Options) Does not have standardized features The writer and the buyer negotiate the specific terms The ability to customize key contract terms: o underlying, exercise prices, exercise styles, and expiration dates Written and guaranteed by the associated clearinghouse Price discovery in competitive and transparent auction markets A secondary market for an opportunity to offset or alter positions before expiration 6

Exotic options Non standard options Can be customized : Flexibility Can be exercised at several specified dates Trade in the OTC markets. Sometimes more expensive than vanilla options 7

Binary Option (Digital option) Completely web-based Simple question : What will the price of the underlying asset do next ? To profit : Will the price go up or down? Correct Lose 8

Binary Option 1 2 9

Benefits of Binary Option Easy and Simple – Choose the direction of the value Controlled Risk – The percentage reward is known from the beginning Protection – A safer option to take if a trader has an open position elsewhere in currency, stocks etc. Punctuality – Issued around the clock, allowing traders to trade on multiple time frames 10

Lookback Option Allow the option holder to trade with hindsight The holder can look back at the price action and exercise the option at the most advantages price Fixed Strike Lookback Option Profit : (price at maturity – fixed strike price) Settled only in cash Floating Strike Lookback Option Profit : (price at maturity – the lowest strike price) 11

Lookback Option Fixed Strike Price Payout Floating Strike Price Payout Fixed Strike Time 12

Benefits of Lookback Option Take away of the problem of market timing Completely maximizes profits within the life of the options BUT Premium can be expensive The risk is when the underlying security does not move by enough 13

Outperformance Option Based on the relative payoff of 2 underlying assets at the maturity date Payout = Max (r A – r B, 0) European and cash settled Can be written on equities, bonds, and currencies Primarily traded in the OTC In the event the asset thought to outperform actually underperforms, the payout is zero 14

Outperformance Option Apple S&P

Outperformance Option 16

Benefits of Outperformance Option Reduce the element of option price volatility When the implied correlation between two assets are greater than +0.5, then outperformance option is cheaper than a plain vanilla 17

Why Market Evolved Exotic Options?? Meet specific and unusual needs of certain clients. Have tax, accounting, or regulatory advantages over standard options. Allow an investment bank to sell an overpriced product to its less technically sophisticated clients 18

Takeaway Points Vanilla option Exotic options and benefits Binary option Lookback option Outperformance option Market and exotic option 19

References performance-option/ performance-option/ iewer?sid=3d6fca64-d58a-43de-aba6-3440e058c80e%40sessionmgr11&vid=33&hid=1 iewer?sid=3d6fca64-d58a-43de-aba6-3440e058c80e%40sessionmgr11&vid=33&hid=1 ption ption ons.htm ons.htm 20

Questions ?? 21

Thank You 22