What is an Exotic Option?

Explanation

At times it is suggested that these options are so-called because they have been inspired by the ‘Exotic’ horse race bets or because some have emerged in Asian countries, which are considered ‘Exotic’ in the west. However, it is best to say that they are so-called because of their lesser-known features that are out of the ordinary.

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Types of Exotic Options

#1 – Quanto Options

  • These are options, with the underlying being one currency and the payoff being another. A name is a short form of Quantity adjusting option. It is purchased due to an expectation that the underlying currency might appreciateCurrency Might AppreciateCurrency appreciation is a rise in the value of a national currency over the importance of international currencies due to an increase in the demand for domestic currency in a global market, a rise in inflation and interest rates, and flexibility of fiscal policy or government borrowing.read more in terms of a third currency; however, the domestic currency of the long party might depreciate against the underlying currency.For example, the Mexican investor believes that the USD will appreciate against the JPY, but the MXN peso will depreciate against the USD, so the gains from the USD might reduce due to loss from MXN. Therefore the payoff will be in MXN, and the profit determination will be in the USD/JPY currency pair. These are cash-settled options

#2 – Binary Options

These options can have only two outcomes, a predetermined payoff if the option is in the money or absolutely nothing if out of the moneyOut Of The Money”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value.read more and therefore these are so named.  These involve a simple high-low prediction, such as whether or not the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more will reach a certain price. If it does, the short pays the long, and if it doesn’t, the short forfeits the initial pot. Such options are more like wagers.

#3 – Lookback Options

In this case, the long can select the highest price of the asset during the option’s life and use it for the profit and payoff determination in the case of a call-like option and, similarly, select the lowest price if it is a put-like option.

#4 – Asian Options

Like the Lookback option, the payoff is determined by taking the average of the underlying prices seen during the lifetime, unlike the American OptionAmerican OptionAn American option is a type of options contract (call or put) that can be exercised at any time at the holder’s will of the opportunity before the expiration date. It allows the option holder to reap benefits from the security or stock at any time when the safety or supply is favorable. A European option is the exact opposite of an American option wherein the option holder cannot sell the option until the day of expiration, even when it is favorable. In addition, there is no geographical connection concerning the names since it only refers to the execution of the options trade.read more or European optionsEuropean OptionsA European option can be defined as a type of options contract (call or put option) that restricts its execution until the expiration date. In layman’s terms, once an investor has purchased a European option, even if the underlying security’s price moves in a favourable direction, the investor cannot take advantage by exercising the option early.read more, which use the Spot price at the expiry.

#5 – Barrier Options

These need activation triggers. There is a predetermined price level; if the underlying reaches this point even once during the option’s lifetime, they get activated. After they are activated, they can be exercised if favorable to the long party; otherwise, they expire worthlessly. There are many more; however, developing a comprehensive list is not a mean task considering that newer contracts emerge frequently.

Features

As such contracts are customized, there can’t be a complete laundry list of the features because options with newer features emerge now and then. However, a few of the features can be elaborated upon to get the idea of the same:

  • Can have Multiple Underlying: An exotic option may be tied to multiple underlying assets, and therefore their profitability will depend on the performance of all these assets and their performancePayoff Determination: Many different kinds of options have varied payoff calculation methods. For example, an option can be customized to use the maximum value of the asset during the option’s life to be compared to the strike price for payoff and profit determination instead of the spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery.read more at the time of expirySettlement Methodology: At times, the options may require physical settlement through the delivery of the underlying asset, or it may be settled through netting the cash flows dependent on the calculation methodology

Barriers in Exotic Option

#1 – Higher Counterparty Risk

The stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more acts as a clearinghouse and the counterparty to all the transactions. However, for this to happen, the contracts need to be standardized, which is not the case with Exotic options. As they are customized, these are part of the OTC market, which has little investor protection, and it all boils down to the negotiations and trust between the parties. This increases the counterparty risksCounterparty RisksCounterparty risk refers to the risk of potential expected losses for one counterparty as a result of another counterparty defaulting on or before the maturity of the derivative contract.read more

#2 – Regulations

Due to the nature of these options, many countries have a highly regulated framework against not allowing some of these. Even if these are allowed, they have resulted in many fraudulent activities. So, most countries refrain from continued trade of these contracts. One such option is the Binary option, which has been considered a highly risk-prone gambling instrument. Many scams are being tracked by the US and Europe related to such options.

#3 – Complexity

Due to their non-standardized features, the payoff and profit calculations become complex. This leads to a requirement of greater due diligence on the part of all the parties entering into the contract to understand what they are getting into clearly.

#4 – Lack of Disclosure

As these are mostly traded in the OTC marketOTC MarketOTC markets are the markets where trading of financial securities such as commodities, currencies, stocks, and other non-financial trading instruments takes place over the counter (instead of a recognized stock exchange), directly between the two parties involved, with or without the help of private securities dealers.read more, the disclosure requirements are very less, and therefore there are greater possibilities of illegal activities undertaken as part of such contracts. According to the FBI’s stats, the scam can amount to USD 10 billion annually in the case of binary options alone.

Example

As there can be several types of exotic options, there can be several examples; one such example can be of Barrier option:

  • Let’s assume that the underlying is the exchange rate between USD and EUR, and the activation exchange rate is USD 2 per EUR. So if it is a knock-in barrier put option on EUR, it will get activated only if the exchange mentioned above is reached during the option’s lifetime.  Suppose that the strike rate is USD 1.5 per EUR, and at the expiry, the Spot is USD 1.8 per EUR.The option will exist only if, during the lifetime, the exchange rate reaches USD 2 per EUR, and then the long will receive a payoff of 1.8-1.5 = USD 0.3 per EUR. If the activation rate has not been reached, the option will not lead to any payoff. The opposite is a knock-out barrier option, which gets extinguished if the deactivation rate is reached; it limits the loss for the short and the gain for the long.

Exotic Option vs. Vanilla Option

  • Cost: Exotic options cost less if they are disadvantageous to the long party. For example, the above-explained barrier option will cost less as they limit the loss of short and the gain of long. They may cost more if they are advantageous to the long, for example, a Lookback option.Trading: Vanilla options trade on an exchange while some of the Exotic options can trade on the exchange; most of such contracts are OTC, due to which the risk associated with the counterparty not fulfilling the contract is higher for Exotic optionsUnderlying: They have a highly varied set of underlying, such as commodities, or highly customized assets, while vanilla options have standardized underlying assets such as stocks and bonds.Calculation: Calculation methodology is more complex in the case of exotic options as compared to vanilla options

Conclusion

Exotic options are special derivative contractsDerivative ContractsDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more designed specifically for the contracting parties to hedge a particular risk or speculate on the expectations of a highly specialized underlying asset. The risk is higher, and therefore the reward is higher too. However, the chances of unfair practices are greater in the case of exotic options; therefore, these transactions are under close watch of regulators.

This has been a guide to What is Exotic Option & its Definition. Here we discuss exotic options, features, examples, barriers, and differences from vanilla options. You can learn more about it from the following articles –

  • Sell Through RateKnock-Out OptionDisclosure StatementOption ChainPut Option Payoff