Exotic Options

EXOTIC OPTIONS

A type of option that differs from common American or

European options in terms of the underlying asset or the
calculation of how or when the investor receives a certain
payoff
Generally trade over the counter
This type of option can change over the holding period

TYPES OF EXOTIC OPTIONS

Barriers options
A type of option whose payoff depends on whether or not the
underlying asset has reached or exceeded a predetermined price.

Binary options
A binary option (also called a digital option) is a cash settled
option that has a payoff either some fixed amount of some asset
or nothing at all. Binary options come in many forms, but the
two most basic are: cash-or-nothing and asset-or-nothing.

BARRIER OPTIONS

A barrier option is like a plain vanilla option but with one

exception: the presence of one or two trigger prices. If the
trigger price is touched at any time before maturity, it causes
an option with pre-determined characteristics to come into
existence (in the case of a knock-in option) or it will cause an
existing option to cease to exist (in the case of a knock-out
option).

KNOCK IN OPTION
Knock In option
A knock in option is an inactive simple option that
automatically becomes live if spot trades at or beyond a
defined barrier (established out of the money in relation to
spot) before expiry.
The closer the knock in (KI) level is to the spot, the more
expensive it is as the probability that the barrier trades, and
thus creating a simple style option, is increased.

KNOCK IN OPTION
Example

The exporter has a bullish view on the EUR/USD. He feels there is a possibility it
could weaken in the near-term. To express this view and to lower the premium cost, the
customer buys a 3 month 0.9400 EUR Call/USD Put with a KI at 0.8900 for 1.2% EUR
(compared to buying the simple option at 1.96% USD). (Spot Reference: 0.9250)
If 0.8900 never trades during the life of the KI option, then no option is created and
the contract expires worthless.
If 0.8900 trades, then the customer becomes long a 0.9400 EUR Call USD Put and can
manage the position accordingly based on his view.
If the spot goes above 0.9400, the exporter will sell Dollar at prevailing spot rate.
Knock in options are generally suited for those with strong directional views or
premium constraints.

KNOCK OUT OPTION

Knock out option

A knock out option is a simple option that automatically

terminates if spot trades at or beyond a defined barrier
(established out of the money in relation to spot) before expiry
The closer the knock out (KO) level is to the spot rate, the less
expensive it is as the probability that the barrier will be
reached is increased.

KNOCK OUT OPTION

Example

A European exporter with US15 million in receivables buys a 3 month 0.9700 EUR
Call/USD Put with a KO at 0.9050 for 0.70% EUR (a simple option without the KO
feature costs 0.97% EUR). (Spot Reference : 0.9250)
If 0.9050 never trades during the life of the option, and:
Spot on expiration is above 0.9700, the exporter sells USD and buys EUR at 0.9700
Spot on expiration is below 0.9700, the exporter sells USD and buys EUR at the
prevailing spot rate
If 0.9050 trades at any time during the life of the option, then the option is
terminated and the buyer will loose the premium

DOUBLE KNOCK IN OPTION

Double Knock In option have 2 trigger points

Double knock in option is an inactive simple option that
automatically becomes live if spot trades at or beyond upper
or lower barriers
A double knock-in option is cheaper than a single knock-in
option because the double knock-in has two trigger prices
either of which could knock the option in

DOUBLE KNOCK IN OPTION

Example:- A German exporter with US15 million in receivables

Buy USD Call/DEM Put Strike 1.5700
with Knock-ins at 1.5400 and 1.6400
Net Premium Cost = 0.21% USD or 33 DEM pips
(vs. comparable European option cost of 1.83% USD or 293 DEM pips).

DOUBLE KNOCK IN OPTION

Spot rates

Trigger hit /miss

Results

Spot above 1.5700 1.6400 not traded

Option not activated and premium

forfeited.
Maximum loss 33 DEM pips

Spot below
1.5700

Option not activated and premium

forfeited.
Maximum loss 33 DEM pips

1.5400 not traded

Spot above 1.5700 1.5400 or 1.6400

traded

DEMs will be purchased at the

prevailing spot rate
And option will be allowed to
lapse

Spot below
1.5700

Option will be exercised at strike

price

1.5400 traded

DOUBLE KNOCK OUT OPTION

Double Knock Out option have 2 trigger points

Double knock Out option is an active simple option that
automatically becomes in active if spot trades at or beyond
upper or lower barriers
A double knock-out option is cheaper than a single knockout option because the double knock-out has two trigger
prices either of which could knock the option out of existence

DOUBLE KNOCK OUT OPTION

Example:- A German exporter with US15 million in receivables

Buy USD Call/DEM Put Strike 1.5700
with Knock-outs at 1.5400 and 1.6400
Net Premium Cost = 0.21% USD or 33 DEM pips
(vs. comparable European option cost of 1.83% USD or 293 DEM pips).

DOUBLE KNOCK OUT OPTION

Spot rates

Trigger hit /miss

Results

Spot above 1.5700

1.5400 or 1.6400 not

traded

Maximum profit 666 DEM pips

Spot below
1.5700

1.5400 not traded

Option lapses and premium

forfeited.
Maximum loss 33 DEM pips will
trade at spot rate

Any closing spot

1.5400 or 1.6400
traded

Option terminated and premium

forfeited.
Maximum loss 33 DEM pips

Payout
Options

Payout Option
An option which has a fixed payof,
triggered by the movement of the
underlying index below or beyond
a range of values

Payout Options
Payout options (also known as "rebate
options), are vanilla put and call options
conditioned by something else other than
just the price and the expiration date
They refer to conditional scenarios that if
come true, either validate or invalidate the
option. The trader fixes the amount of the
desired payout he will get if his conditional
scenario proves to be right
The price of the option or premium
represents a percentage of that payout

Types of Payout Options

One Touch Option

No Touch Option

Double One Touch Option

Double No Touch Option

One Touch Option

An option that gives an investor a
payout once the price of the
underlying asset reaches or surpasses
a predetermined barrier.

Option allows:
to set the level of the barrier
the time to expiration
the payout to be received once the
barrier is broken

One Touch Option

Reason for using One Touch Option:

One Touch buyer

Strong directional view
Fixed Risk-Reward

One Touch seller

Alternative to short Standard Option in Risk
Reversal
Limited downside

Alternative names used:

Touch Digital Option

Lock-In Option

One Touch Option

Two outcomes possible with this
type of option:
the barrier is broken and the
investor collects the full payout ,
or
the barrier is not broken and the
investor losses the full premium

Example
Market Data

Product Data

Currency:
EUR/USD

Spot: 1.3000

Type: OT
Expiry: 3 month
Payout: 100,000 EUR
Trigger: 1.3700
Premium: 30% of
Payout

One Touch Option

If barrier is brokenthen
Right to receive fixed payout of 100,000 EUR
Payout if spot reaches 1.3700 on/before
expiration
Up front premium is 30% of payout(30,000
EUR)

If barrier is not brokenthen

Up front premium is 30% of payout (30,000 )

Applications of
One Touch Options
Used by speculative market
participants
As a tool for hedging

Double One Touch Option

An option that gives the investor a payout
at/before expiry if the price of the
underlying asset DOES reach or surpass
one of two predetermined barrier levels.
Option allows:
The right to choose the level of the
barriers
The time to expiration
Payout to be received if the price breaks
either barriers

Double One Touch Option

Reasons for using a Double One Touch
Option:
Benefit from range bound spot market
High Volatility with limited downside
(premium)
Fixed Risk-Reward
Do not know the direction in which market
will move

Double One Touch

Option
Two outcomes possible with this type
of option:
the barrier is broken (touches either of the
barriers) and the investor collects the full
payout , or
the barrier is not broken and the investor
losses the full premium

Example
Market Data

Product Data

Currency: USD/JPY Type: DOT

Expiry: 3 month
Payout: 100,000 USD
Spot: 103.00
Upper Barrier: 106.0
Lower Barrier: 99.0
Premium: 20% of
Payout

Double One Touch Option

If barrier is brokenthen
Right to receive fixed payout of 100,000
USD as spot does not reach 99.0 or 106.0
on/before expiration.
Up front premium is 20% (20,000 USD)

If barrier is not broken.......then

Up front premium is 20% (20,000 USD)

No Touch Option
Pays a fixed amount if Trigger is
NOT touched during life of option
Quoted as % of Payout (Pay 20% receive 100% if not touched)

No Touch Option
One Touch and No Touch prices are
connected
Probability of NOT touching
Probability of touching = 100%

P/L of buying a One Touch Option is the

same as selling the No Touch Option
with the same trigger

NO TOUCH OPTION
Reason for using No Touch Option:
Limited risk
Low volatility

Alternative name used:

Lock Out

Example
Market Data

Product Data

Currency:
USD/JPY

Spot: 103.00

Type: NT
Expiry: 3 month
Payout: 100,000 USD
Barrier: 106.0
Premium: 20% of
Payout

No Touch Option
Two outcomes possible with this type
of option:
the barrier is not broken and the
investor collects the full payout , or
the barrier is broken and the investor
losses the full premium

Double No Touch Option

An option that gives the investor a payout
at/before expiry if the price of the
underlying asset does NOT reach or
surpass one of two predetermined barrier
levels.
Option allows:
The right to choose the level of the
barriers
The time to expiration
Payout to be received if the price fails to
break either barriers

Double No Touch Option

Reasons for using a Double No Touch
Option:

Benefit from range bound spot

market

Low Volatility with limited

downside (premium)
Fixed Risk-Reward
Alternative names used:

Double Lock-Out Option

Double No Touch Option

Two outcomes possible with this type
of option:
the barrier is not broken (does not
touch either of the barriers) and the
investor collects the full payout , or
the barrier is broken and the
investor losses the full premium

Example
Market Data

Product Data

Currency:
USD/JPY

Spot: 103.00

Type: DNT
Expiry: 3 month
Payout: 100,000 USD
Upper Barrier: 106.0
Lower Barrier: 99.0
Premium: 20% of
Payout

Double No Touch Option

If barrier is not brokenthen
Right to receive fixed payout of 100,000 USD
as
spot does not reach 99.0 or 106.0
on/before expiration.
Up front premium is 20% (20,000 USD)

If barrier is brokenthen
Up front premium is 20% (20,000 USD)

Binary
Options

Digital Options
Cash-or-Nothing
Asset or Nothing

Cash Or Nothing
Cash or Nothing Call
This pays out one unit of cash if the spot is
above the strike at the maturity.

Cash Or Nothing
Cash or Nothing Put
This pays out one unit of cash if the spot is
below the strike at the maturity.

Asset Or Nothing
Asset or Nothing Call
This pays out one unit of Asset if the spot is
above the strike at the day of maturity.

ASSET OR NOTHING
Asset or Nothing Put
This pays out one unit of Asset if the spot
is below the strike at the day of maturity.

Forward Start Option

FORWARD START OPTIONS

A forward start option is an advance purchase of a put or call option

that will become active at some specified future time.

The underlying and time to expiration are specified at that time.
The strike price is determined when the option becomes active.
It is set at-the-money based upon the underlying value at that time.

Example
A company may buy a three month EUR put
(GBP call) to start one month later. The
premium is paid immediately but in one month
the buyer receives a three month option with
strike set at which the ATM rate is at that time.
Spot price rising from an initial EUR/GBP
0.6600 to 0.7000 after one month; where strike
is set at 0.7000for the three month plain
vanilla option.

Spot Price

Payoff Graph

Jan Feb Mar Apr May

Jun

Why use a forward start option?

An application of forward start

options is employee stock options.

LookBack Option

LOOKBACK OPTIONS
Allows the holder to "Look Back" at the
price action of the underlying asset
during expiration to decide the optimal
price at which to exercise Option

LookBack Options - An Illustration:

Ordinary Call Options: Buy Ordinary call options at $100 strike price .
Asset price touches $150. You are holding it.
Asset price drops just to $80 upon expiration.
You lose all your money and regrets the decision to hold.
LookBack Call Options: Buy LookBack Call Options at $100.
Underlying asset rallies to $150. You are holding it.
Asset price drops to $80 upon expiration.
Instead of regretting to hold, simply exercise LookBack Call
Options at highest price of $150 and profit is $50.

Types of LookBack Option

LookBack
Fixed Strike
Floating
Options
Strike
LookBack
LookBack

Fixed Strike LookBack Options

Option's strike price is fixed at purchase.

Settled only in cash.
Option is not exercised at the market price:
For call(put), highest(lowest) underlying value
achieved, so a payoff is equal to greater of: zero
or difference between that highest value and
fixed strike(strike price and lowest value).
Exit problem is solved, but entry problem isnt.

Spot Price

Payoff Graph

Jan Feb Mar Apr May

Jun

Floating Strike LookBack Options

Strike price is fixed at maturity
For call, optimal value is lowest value achieved by
underlier, payoff equal to difference between value of
underlier at expiration and lowest value achieved by
underlier over life of option
For put, payoff is difference between, highest value
achieved by underlier and value of underlier at expiration
Gives market entry solution
Considered to be quite speculative

Payoff Graph

Spot Price

11
0

80
Jan Feb

Mar

AprMay

Jun

Advantages
Lookback call owner can buy at lowest
price
Lookback put owner can sell at highest
price
Lookback option can never be out-of-the
money
Completely eliminates market entry and exit
timing problems.

Disadvantages
Expensive
Not publicly traded

Compound
Options

Buyer of Call and Put Option

Buying a Call Option means Buying the
right to Buy the currency at the strike price.
e.g. Buy USD call with strike price 49.50

Buying a Put Option means Buying the

right to Sell the currency at the strike price.
e.g. Buy USD put with strike price 49.50

Seller of Call and Put Option

Selling a Call Option means Selling the
right to Buy the currency at the strike
price.
e.g. Sell USD Call with strike price 49.50
Selling a Put Option means Selling the
right to Sell the currency at the strike
price.
e.g. Sell USD Put with strike price 49.50

Compound Options
A compound option (called the mother
option) gives the holder the right, but not
obligation to buy (long) or sell (short) the
underlying option (called the daughter
option).
(Compound) Option
0

Underlying Option

t1

Underlying Asset

t2

At time=0 we buy an option that gives the right to

buy/sell at time=t1 another option at the price of x1which
in turn gives the right to buy an underlying asset at the
price of x2.

Types of Compound Options

Call on a Call
Call on a Put
Put on a Put
Put on a Call

Call on Call & Put on Put

(Importer)
45.
5

46

46.
5

4
7

47.
5

4
8

49.
5

50

51 51.
5

53

Buy
USD
call
49.50

0.5
0

1.5

3.5

Sell
USD
put
46.50

-1

-0.5

Net

-1

-0.5

0.5

1.5

3.5

Call on Put & Put on Call

(Exporter)
40

40.
5

41

41. 42 42.
5
5

43

43.
5

44

44.
5

Buy
USD
put
43.8
0

3.80

3.30

2.80

2.30

1.8
0

1.30

0.80

0.30

Sell
USD
call
42.7
0

1.3
0

1.80

-0.80
0.30