What is Exotic Option?
Exotic options, as the name suggests, are more complex variations of the simple vanilla options, in terms of trigger points, payoff determination, expiry, underlying assets and other such features of the same, designed suiting to the needs of the partaking investors and therefore sell through the Over-the-Counter (OTC) market.
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.
Types of Exotic Options
#1 – Quanto Options
- These are options with underlying being one currency and payoff being in another. A name is a short form of Quantity adjusting option and it is purchased due to an expectation that the underlying currency might appreciate 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 USD will appreciate against JPY but MXN peso will depreciate against USD so the gains from USD might reduce due to loss from MXN, therefore the payoff will be in MXN and the profit determination will be in terms of the USD/JPY currency pair. These are cash-settles options
#2 – Binary Options
These are options that can have only two outcomes, a predetermined payoff if the option is in the money or absolutely nothing if out of the money and therefore these are so named. These involve a simple high low prediction such as whether or not the underlying asset will reach a certain price. If it does the short pay the long and if it doesn’t the short forfeits 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 life of the option and use it for the profit and payoff determination in case of a call like and option and similarly, select the lowest price if it is a put like the option.
#4 – Asian Options
Similar to the Lookback option, the payoff is determined by taking the average of the prices the underlying has seen during the lifetime unlike the American Option or European options, which use the Spot price at the expiry.
#5 – Barrier Options
These need activation triggers. There is a predetermined price level, and if the underlying reaches this point even once during the lifetime of the option, 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 of these however developing a comprehensive list is not a mean task considering that newer contracts emerge frequently.
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As such contracts are customized, there can’t be a complete laundry list of the feature because options with newer feature emerge every now and then, however, a few of the feature 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 performance
- Payoff Determination: There are many different kinds of options having varied payoff calculation method, for example, and option can be customized to use the maximum value of the asset during the life of the option to be compared to the strike price for payoff and profit determination, instead of the spot price at the time of expiry
- Settlement 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 exchange 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 risks
#2 – Regulations
At times due to the nature of these options, many countries have a highly regulated framework against not allowing some of these and even if these are allowed, they have resulted in a large number of fraudulent activities and so, most countries refrain from continued trade of these contracts. One such option is the Binary option, which has been considered as a gambling instrument and highly risk-prone. 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 so that they clearly understand what they are getting into.
#4 – Lack of Disclosure
As these are mostly traded in the OTC market, the disclosure requirements are very less and therefore there are greater possibilities of illegal activities undertaken as part of such contracts. As per the FBI’s stats, the scam can amount up to USD 10 billion annually in case of binary options alone.
As there can be several types of exotic options, there can be several examples, once 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 a barrier put option on EUR, the option will get activated only if the above-mentioned exchange rate is reached during the lifetime of the option. Now 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 reached 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 reached then the option will not lead to any payoff. The opposite of this is a knock out barrier option which gets extinguished if the deactivation rate is reached, it limits the loss for the short and gain for the long.
Exotic Option vs Vanilla Option
- Cost: Exotic options cost less in case 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 to the counterparty not fulfilling the contract is higher for Exotic options
- Underlying: 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 case of exotic options as compared to vanilla options
Exotic options are special derivative contracts 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 case of exotic options, and therefore these transactions are under the close watch of regulators.
This has been a guide to What is Exotic Option & its Definition. Here we discuss the types of exotic options, features along with examples, barriers, and differences with vanilla options. You can learn more about from the following articles –