Exotic derivatives are customized to fit a specific firm need for hedging that cannot be met by plain vanilla derivatives.
Reasons for developing exotic derivatives:
A package is defined as some combination of standard European options, forwards, cash & the underlying asset., example – straddle, bull, bear etc. Because packages often consist of a long position and at short position, they can be constructed so that the initial cost of the investor is zero.
When some changes are made to standard feature of options, standard options become non standard options. Three common features that transform standard options into non-standard are:
If ST > X2 , Payoff = ST – X1
ST ≤ X2 , Payoff = 0
If X2 ≤ X1 Payoff = X2 – X1
If ST < X2 , Payoff = X1 – ST
ST ≥ X2 , Payoff = 0
If X2 ≥ X1 Payoff = X2 – X1
Hedging exotic options requires replication of portfolio. It may require further futures adjustment called Dynamic options replication. Dynamic options replication requires frequent trading which makes it costly to implement.
As an alternative, a static options replication is used in which a short portfolio of actively traded options is created which drastically reduces the transaction costs associated with dynamic rebalancing.
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