Exotic Options – Definition and Types

An option contract is a derivative product, that provides the buyer a right to buy or sell the underlying asset at a certain price, at or during a specific maturity (You can read more about that here).

Typology of Options

Options according to exercise term:

• American Types
• European Types

Options according to payoff structure:

• Vanilla Types
• Exotic Types

Options according to the direction of use:

• Call Options
• Put Options

Exotic options are the classes of option contracts with structures and features that are different from plain-vanilla options. They are products of financial engineering, which is the application of science-based mathematical models.

Exotic options allow investors to expand the available range of risk management opportunities. They are mainly used:

• by firms to create more appropriate hedge structures for their risk exposures
• by portfolio managers to enhance their assets yield
• by financial institutions to deal with their asset and liability mismatches

Types of Exotic Options

• Interest-Rate
• Barrier Caps and Floors
• Quanto
• Spread
• Range Accrual

1. Interest-Rate

Interest-rate exotic options usually are path-dependent, correlation-dependent, time dependent or a mix of these features:

• Path-dependent options: option payoffs are a function of the path that interest rates follow over the option life.
• Correlation-dependent options: option payoffs are based on the relationship between several interest rates.
• Time-dependent options: the buyer has the right to choose an option characteristic as a function of time.

2. Barrier Caps and Floors

A barrier cap or floor provides a payoff depending on whether the reference rate has reached a prespecified level called a barrier during a certain period of time (American style) or at expiration
date (European style).

3. Quanto

A quanto is an option in which the underlying is denominated in one currency, but the payout is settled in another currency using a predefined spot rate.

This lets an investor to participate in foreign assets without the currency exposure inherent in purchasing that asset.

Assets denominated in one currency with reference to an underlying originally based in another currency at a fixed exchange rate.

There are two Major inputs for valuing quanto asset:

1. Forward price of the underlying asset adjusted for cost of hedging the FX risk.
2. Discount factor for the payout, using the rate of the currency into which the asset is being quantoed.

The price of a quanto asset can be found by computing the price of the corresponding conventional asset with shifted forward foreign rate and discounting the payout at the quanto currency payout rate instead of the payout currency of the underlying asset. This applies regardless of the complexity of the payout.

4. Spread

A spread option is an option whose payoff depends on the difference between two rates. These
two rates can either be extracted or not from the same yield curve.

Spread options are typically used to semihedge some active positions like butterfly trades whose
aim is to bet on flattening or steepening move of the yield curve. When you bet on a steepening move, you want to be hedged against a flattening move, so you buy a spread option.

5. Range Accrual

A range accrual swap, sometimes called corridor, is a swap in which the interest on the fixed leg accrues only when a floating reference rate is in a certain range. The range can be fixed or moves during the product life. This product is used by investors who anticipate that rates will remain stable into a range, or, on the contrary, anticipate that rates will be affected by a large volatility.

The Bottom Line

Exotic options are different from traditional options in their expiration dates, exercise prices, payoffs, and underlying assets. They are mainly used by firms to create more appropriate hedge structures for their risk exposures, by portfolio managers to enhance their assets yield, and by financial institutions to deal with their asset and liability mismatches.

To keep learning and advancing your knowledge of derivatives, the following resources will be helpful:

• Derivatives 101: Overview & Types
• What is a Forward Price? Definition & Formulas
• Futures Contracts: Overview & Basics
• Swaps: Definition & Types