## BASIC #

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:**

- Provide a unique hedge for a firm’s underlying assets.
- Addressing tax and regulatory concerns.
- Speculating on the expected future direction of market prices.

## PACKAGES TO FORMULATE A ZERO-COST PRODUCT #

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.

## TRANSFORMING STANDARD AMERICAN OPTIONS INTO NON STANDARD AMERICAN OPTIONS #

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:

- Restrict early exercise to certain dates. – Bermudan options.
- Early exercise can be limited to a certain portion of the life of the option.
- The options strike price may change.

## EXOTIC OPTION PAYOFF STRUCTURES #

**GAP OPTIONS :**A gap option has two strike prices, X_{1 }& X_{2}(trigger price).

**GAP CALL OPTION****:- If X**_{2}> X_{1}

** **If S_{T }> X_{2} , Payoff = S_{T } – X_{1}

_{ }S_{T }≤ X_{2} , Payoff = 0

**If X _{2} ≤ X_{1} **Payoff = X

_{2 – }X

_{1}

**GAP PUT OPTION****:- If X**<_{2 }**X**_{1 }

** _{ }**If S

_{T }< X

_{2}, Payoff = X

_{1 }– S

_{T }

_{ }S_{T }≥ X_{2} , Payoff = 0

**If X _{2} ≥ X_{1} **Payoff = X

_{2 – }X

_{1}

**FORWARD START OPTIONS:**Options that begin their existence at sometime in the future. Example: Employee incentive plan.**COMPOUND OPTIONS:**Compound options are options on options. Compound options have two levels of the underlying that determines their value – the value of the underlying option which in turn is determined by the value of the underlying asset. It consists of two strike price & two exercise dates.

- A call on a call gives the investor the right to buy a call option at a set price for a set period of time.
- A call on a put gives the investor the right to buy a put option at a set price for a set period of time.
- A put on a call gives the investor the right to sell a call option at a set price for a set period of time.
- A put on a put gives the investor the right to sell a put option.

**CHOOSER OPTIONS :**Allows the owner to choose weather the options is a call or a put after a certain period of time.**BARRIER OPTIONS :**Options whose payoff depends on weather the underlying’s asset price reaches a certain barrier level over the life of the option. Specific types of barrier options are:

**Down-and-out call (put**). A standard call (put) option that ceases to exist if the underlying asset price hits the barrier level, which is set below the current stock value.**Down-and-in call (put)**. A standard call (put) option that only comes into existence if the underlying asset price hits the barrier level, which is set below the current stock value.**Up-and-out call (put**). A standard call (put) option that ceases to exist if the underlying asset price hits a barrier level, which is set above the current stock value.**Up-and-in call (put**). A standard call (put) option that only comes into existence if the underlying asset price hits the above-current stock-price barrier level.

**BINARY OPTIONS :**Options payoff has one of two states: The option pays a set dollar amount at expiration if the option is above the strike price, or the option pays nothing if the price is below the strike price.

**Cash – or – nothing call :**Fixed amount is paid if the asset ends up above the strike price.**Asset – or – nothing call :**Pays the value of the stock when the contract is initiated if the stock price ends up above the strike price at expiration.

**LOOKBACK OPTIONS:**Options whose payoff depends on the maximum or minimum price of the underlying asset during the life of the option

**Floating look back call:**Pays minimum price – Expiration price**Floating look back put :**Maximum price – Expiration Price**Fixed lookback call :**It is identical to a European call option except the expiration price is the maximum price during the option’s life.**Fixed lookback Put :**Payoff is like European Put option but replaces the final stock price with the minimum price during the option’s life.

**SHOUT OPTIONS :**It allows the holder to receive either the intrinsic value of the option at the*shout date*or at expiration, whichever is greater.**ASIAN OPTIONS :**Asian options have payoff profiles based on the average price of the security over the life of the option. Average price calls & puts payoff the difference between the average stock price & the strike price.**EXCAHNGE OPTIONS :**It is used to exchange one currency with another.**BASKET OPTIONS :**Options to purchase or sell baskets of securities. Basket may consist of specific stocks, indices or currencies.

## VOLATILITY & VARIANCE SWAP #

**VOLATILITY SWAP**: Exchange of volatility based on a notional principal.**VARIANCE SWAP :**It involves exchange a pre specified fixed variance rate for a realized variance rate.

## ISSUES IN HEDGING EXOTIC OPTIONS #

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.