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Exotic Options

Aaron Bany May 21, 2013 BA 543-002 Financial Markets and Institutions. Exotic Options. What is an option?. A financial derivative that represents a contract sold by one party (writer) to another party (holder)

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Exotic Options

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  1. Aaron Bany May 21, 2013 BA 543-002 Financial Markets and Institutions Exotic Options

  2. What is an option? • A financial derivative that represents a contract sold by one party (writer) to another party (holder) • It offers the holder the right, but not the obligation, to exercise the option to either buy or sell an underlying asset when predetermined conditions are met

  3. How Options Function Option = f(S, K, T, rf, σ) S = share price K = strike price T = time to maturity rf= risk free rate σ = volatility of underlying asset

  4. 2 Types of Options • Vanilla Options (2 forms) • American Option • European Option • Exotic Options (unlimited) • Bermuda Options • Chooser Options • Performance Options • Compound Options • Binary Options • Barrier Options • Asian Options • Lookback Options • Etc.

  5. Exotic Options • The term “exotic” was popularized by Mark Rubinstein in 1990 • Used to describe any option that is more complex than a vanilla American or European option

  6. Binary Options • It either pays out or it doesn’t • 2 types • Cash-or-Nothing • Pays the fixed amount if the asset is “in-the-money” • Asset-or-Nothing • Pays the value of the underlying

  7. Barrier Options: Knock-In • Up-and-in: activated by moving up and beyond the barrier • Down-and-in: activated by moving down and beyond the barrier • Knock-In Call option – Asset begins the day at $75 Scenario 2 Time = 1 day Strike Price = $80 Barrier Price = $90 Closing Price = $95 Call Payout = $15 Scenario 1 Time = 1 day Strike Price = $80 Barrier Price = $90 Closing Price = $85 Call Payout = $0

  8. Barrier Options: Knock-Out • Up-and-out: deactivated by moving up and beyond the barrier • Down-and-out: deactivated by moving down and beyond the barrier • Knock-Out Call option – Asset begins the day at $75 Scenario 4 Time = 1 day Strike Price = $80 Barrier Price = $90 Closing Price = $95 Call Payout = $0 Scenario 3 Time = 1 day Strike Price = $80 Barrier Price = $90 Closing Price = $85 Call Payout = $5

  9. Barrier Options One-Touch No-Touch Double No-Touch Double One-Touch

  10. Why Binary and Barrier Options? • You don’t have to be an expert trader • You know the risk and payoff • Short time to maturity • High payout • ROI of 50-70% • Linked to the direction the asset trending and not the difference in price

  11. Asian Options • Originated in Tokyo, Japan in 1987 • Payoff is based on the average price of the asset over a pre-set period of time • Fixed Strike – payoff is the difference between the strike price and average value • Floating Strike – payoff is the difference between value at expiration and average value

  12. Asian Option Example Fixed Strike Floating Strike Average = $102 Pre-Set Strike = $80 Call Payout = $22 Put Payout = $0 Average = $102 Strike @ maturity = $110 Call Payout = $0 Put Payout = $8

  13. Why Asian Options? • Reduce the dependence of the value of the option on the spot price of the asset on a specific date • Less expensive because its volatility is usually less then the underlying assets spot price

  14. Lookback Options • Payout depends on the underlying assets maximum (call) or minimum (put) price over the life of the option • Fixed Strike – payoff is the difference between a pre-set strike and the min or max value • Floating Strike – payoff is the difference between optimal price (the strike) and the min or max value

  15. Lookback Options Fixed Strike Floating Strike Highest Price = $130 Lowest Price = $75 Call Payout = $55 Put Payout = $55 Pre-Set Strike = $95 Highest Price = $130 Call Payout = $35 Lowest Price = $75 Put Payout = $20

  16. Why Lookback Options? • It eliminates the market entry and exit problems • Completely maximizes profit

  17. Mini Quiz: Q1 The current price of a stock is trading at $2.50. The trader believes that the stock has high volatility and could rise above $2.55 or drop below $2.45. What is the best option to capitalize on this scenario? Asian Option Lookback Option Binary Option Double One-Touch Option Double One-Touch

  18. Mini Quiz: Q2 A trader buys a European call option with X = $100, that is trading at $100. The asset falls to $70 before rallying to $120. The trader decides to hold it to see if it will rally higher, but it falls to $80 at maturity. What option gives the highest payout? Asian Option Lookback Option Binary Option Double One-Touch Option

  19. Questions

  20. Sources • http://www.optiontradingpedia.com/ • http://www.investopedia.com/ • http://www.thetaris.com/wiki/Look_Back_Option • http://www.thetaris.com/wiki/Asian_Option • Bermin, H., Buchen, P., & Konstandatos, O. (2008). Two Exotic Lookback Options. Applied Mathematical Finance, 15(4), 387-402. doi:10.1080/1350486080201282

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