exotic options

Question 1

what do we mean by exotic options

Answer 1

Take the standard option, and create custom terms

Question 2

what is the purpose of exotic options

Answer 2

Tailor a risk management security

Question 3

name the option types we’re interested in

Answer 3

1) Asian
2) Barrier
3) Gap
4) compound
5) exchange

Question 4

why not by strips of regular options to provide a hedge against something like the Euro?

Answer 4

Many transactions, higher transaction costs.

Question 5

if someone want to hedge exchange rate risk, how could they do it in a way that makes sense? Why miught regular european options not be that suitable?

Answer 5

European options only provide risk managment on the expiration date.

if our business need is sort of like “continuous” operations, we would like to always be protected. If we have a way to consider the “average” price of the euro, rather than only at expiration, we are closer to being safe.

say we buy a put option that instead of “price at expiration” use “average price, computed from 0 to T”. If the average price of the euro is low, we would be able to hedge this by force-selling at the higher level

This is an asian option

Question 6

can we delta hedge using exotic options?

Answer 6

Generally, yes

Question 7

elaborate on asian options as a whole

Answer 7

Asian options refer to options that has a payoff that is based on the average price of the underlying.

As a result, asian options are path dependent.

Question 8

term used to describe “settlement based on the average”?

Answer 8

asian tail

Question 9

Why is “settlement based on the average” referred to as asian tail?

Answer 9

Because the averaging happen at termination

Question 10

At issuance, what is more valuable: Regular, or asian options?

Answer 10

Regular.

Asian options are worht less than regular options because the average stock price is less volatile

Question 11

what types of asian options are there?

Answer 11

we have 8, created by combinations of the following:

1) put vs call
2) geometric vs arithmetic average
3) whether the average is done on the asset price or the strike price

Question 12

elaborate on arithmetic vs geometric average

Answer 12

arithmetic is defined as: 1/n ∑xj [j=1, n]

geometric average is defined as:

(∏sj)^(1/n)

Question 13

elaborate on using average strike price, rather than average price

Answer 13

average strike price is a confusing terminology. What it actually means, is that instead of using the fixed strike price K, we use the average price of the asset to be the strike price.

So for both types of asian options, the same “average” is used, it just depends whether it is used in place for the asset price or the strike price.

Question 14

what happens with the asian option if the number of periods used in the average computation is 1?

Answer 14

we use the final value, and the option becomes a regular vanilla option

Question 15

what can we say about an “average price option” if we increase the number of values(prices) used to find the average?

Answer 15

The price of the option becomes lower, as the volatility decrease.

Question 16

what can we say about an “average strike option” if we increase the number of values (prices) used in the average?

Answer 16

Price will increase.

Question 17

what kind of option is this?

Answer 17

asian put arithmetic average price option

Question 18

elaborate on barrier options

Answer 18

a barrier option has a value dependent on whether it reached a specific barrier during the time between issuance and expiration.

Interesting about barrier options is that they come into existence, or go out of existence the first time they reach their barrier.

if the barrier option is “in existence” at expiration, the payoff is equal to a regular option. However, if the barrier was never reached, there is no payoff.

Question 19

are barrier options path dependent

Answer 19

obviously. we need to track whether they have reached the barrier or nto

Question 20

what types of barrier options do we have?

Answer 20

1) Knock-out
2) knock-in
3) rebate options

Question 21

elaborate on knock-out barrier options

Answer 21

These go OUT of existence if the barrier is reached.

We differ between “down and out” and “up and out”.

terms on the option desrcribe which one it is.

Question 22

elaborate on knock-in barrier options

Answer 22

they come into existence if they reach their barrier. we differ between “up-and-in” and “down-and-in” depending on whether the asset price has to reach a ceiling, or a floor, to be activated.

Question 23

elaborate on rebate options

Answer 23

These make a fixed payment if the barrier is reached. we have “up rebates” and “down rebates”.

The payment can occur either at the time of barrier breach, or at expiration.

Question 24

what is the parity equation for barrier options+

Answer 24

knock-out + knock-in = ordinary option

For instance.

down-and-in call + down-and-out call = call

Question 25

if we want to hedge a currency, how can we do it with barrier options

Answer 25

we have 2 possibilities: 1) up-and-out puts 2) down-and-in puts Both of these will provide support when we need it. The up and out is shady, because if the currecny is good, only for a short time, we risk knocking away our protection.

Question 26

what is a compound option

Answer 26

Option to be an option

Question 27

elaborate on compound options

Answer 27

they are complicated because we have 2 strike prices, and two expirations. We refer to the outer option as the "compound option". The compound call option gives us the right to exercise it, which means right to buy the underlying option at some prespecifeid strike price. The underlying option must expire after the compound option expire.

Question 28

At time t1, when the compound option expires, what is the value of the compound option?

Answer 28

max[0, C(S,K,T-t1) - X], where X is the strike price on the compound option. So the relationship is basically the same, except that there is not a stock price, there is an option price.

Question 29

when does it make sense to exercise a compound option?

Answer 29

If the stock price is to large that the underlying option is valuable, more valuable than the strike price that is, we can exercise with profit.

Question 30

what events must take place in order for the compound option to ultimately be valuable?

Answer 30

1) First, it must be worthwile to exercise the compound call, i.le. buying the option. This happens if, at expiration of the compound, the call is worth more than the strike price X of the compound option. If this happens, we exercise, which entails buying the call. 2) The inner call option must finish/exercise ITM at time=T.