Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull Exotic Options and Other Nonstandard Products Chapter 23

Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull Types of Exotic Options Forward start options Compound options Chooser options Barrier options Binary options Lookback options Shout options Asian options Previous student ideas Ongoing work on crop Insurance Options

Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull Forward Start Options (page 444) Option starts at a future time, T Most common in employee stock option plans Often structured so that strike price equals asset price at time T Use standard methods to find fair rate, then discount back

Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull Compound Option (page 444) Option to buy or sell an option, two strike prices and two exercise dates Call on call (at first exercise date the owner can buy a call at the preset strike) Put on call Call on put Put on put To find fair value use excel to generate hundreds of options and use if then statement to find average payout across these options

Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull Chooser Option “As You Like It” (page 445) Option starts at time 0, matures at T 2 At T 1 (0 < T 1 < T 2 ) buyer chooses whether it is a put or call To find the fair value generate the call and put value at each observation and use the Max(..) statement

Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull Barrier Options (page 445) In options: come into existence only if asset price hits barrier before option maturity Out options: are knocked out if asset price hits barrier before option maturity To find the fair premium use an if, then statement to determine if the option comes into existence then find the average payout on those that do. Adjust for the probability of coming into existence

Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull Binary Options (page 446) Cash-or-nothing: pays Q if S > K at time T, otherwise pays 0. Value = e –rT Q N(d 2 ) Asset-or-nothing: pays S if S > K at time T, otherwise pays 0. Value = S 0 N(d 1 ) To find fair value use Q as the payout instead of s-k

Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull Lookback Options (page 446) Lookback call pays S T – S min at time T Allows buyer to buy stock at lowest observed price in some interval of time Lookback put pays S max – S T at time T Allows buyer to sell stock at highest observed price in some interval of time To find fair value use the min or max commands to find relevant trigger prices and use these in the payout expression

Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull Shout Options (page 447) Buyer can ‘shout’ once during option life Final payoff is either Usual option payoff, max(S T – K, 0), or Intrinsic value at time of shout, S  – K Payoff: max(S T – S , 0) + S  – K Similar to lookback option but cheaper Will show fair value calculation as an exercise

Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull Asian Options (page 447) Payoff related to average stock price Average Price options pay: max(S ave – K, 0) (call), or max(K – S ave, 0) (put) Average Strike options pay: max(S T – S ave, 0) (call), or max(S ave – S T, 0) (put) We did the fair value calculation in Homework 3

Previous student ideas Diesel price price insurance. Provide trucking companies with insurance against high diesel prices An option on the S&P volatility (this became the vix) Rangeland insurance Futures on rental rates in key cities Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull

Current work; background All federally reinsured crop policies must be sold at the same premium by all insurance companies (no discounting) This has created an incentive for companies to add private bells and whistles Grain elevators have enormous fixed costs and desperately want to maximize throughput. Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull

Ideas A private hail policy where the indemnity depends on the yield loss not insured by the underlying policy (production hail) An FCIC crop gross margin policy to be sold in August 2014 An FCIC policy to insure revenue as many as five years into the future A private shout option on crop insurance Forward contract protection insurance (private) Business interruption insurance at the county level using GRP rates (private) Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull