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Introduction to Exotic Options
FX Derivatives Seminar27th November 2004
Raphael Drescher
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Derivatives
People generally use derivativesfor:
Hedging
Implementing a View
Hedge an exposure with aforward.
Advantage - no risk (except basis).
Disadvantage - lose opportunities
Hedge an exposure with anoption.
Advantage - keep opportunities.
Disadvantage - premium
Basis
Vo
latility
Value
EuropeanOption
AmericanOption
Early Exercise
Forward Spot
Standard Derivatives
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Exotic Options
What are Exotic Options ?
Non-standard options
Options with additional features or functionality
Path-dependent (most exotic options) Second / Third generation products
What Exotic Options are NOT
Options on exotic currency pairs
Cure for bad positions
High quality for low cost --> You get what you pay for
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What can be non-standard
The Type of Option
Doesnt have to be a Call nor a Put
payoff may be a a fixed amount or Max[0 , f()], or...
The Underlying may not be a traded underlying, e.g., volatility
The Underlying Price
may be an average price or a maximum price
The Strike Price
may be an average price or a maximum price
Conditional Events payoff may depend on spot trading within a range, above/ below certain
levels
Payout may be in an other currency
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Exotics : Why do we need them ?
More cost effective products
Dont pay for hedging you dont need
Reduction of premium at risk
Greater scope to express specific views
Provide optical value
Embed spot views into hedging strategies
Greater gearing/leverage for speculative strategies
But bad product choices can cause problems
Spot Forwards Options Exotics
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Barrier Options
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SECTION 1
Path dependent
Spot
Time
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Barrier Options I
The value of a standard option is related to the expected futurevalue (intrinsic value)
The value of a barrier option is as well related to the expectedfuture value under either one or both of the following conditions:
The outstrike has never been touched during lifetime of theoption
The instrike has been touched during lifetime of the option
The payout (intrinsic value) of a barrier option is exactly the sameas the one of a standard option, again under the condition thatthe outstrike is never reached or the instrike is touched.
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Barrier Options II
Prices of barrier options are also influenced - besides outstrikes orinstrikes - by spot, strike price, interest rates, time till expirationand implied volatility, although in a complete different mannerthan for standard options
Risk parameters (Delta, Gamma, Tau, etc.) might be significantlydifferent than those of standard options
This fact has implication in terms of risk management for both,the client and the bank
and makes those options look attractive
better hedging variations with exotic options possibility of expressing a market view through different strategies
tailor made zero upfront premium strategies
leverage of exotic options are very big more delta for less premium
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Barrier options terminology
Options with OUT- strikes:
The option starts active
Down-and-out: Barrier lies below the spot
The option deactivates if the spot price drops below the barrier Up-and-out: Barrier lies above the spot
The option becomes inactive if the spot rises above the barrier
Options with IN- strikes
The option starts inactive
Down-and-in: Barrier lies below the spot
The option only activates if the spot price falls below the barrier
Up-and-in: Barrier lies above the spot
The option activates only if the spot rises above the barrier
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100 Vanilla Call
Spot at expiry above 100 = Option has a value
Spot at expiry below 100 = Option has Zero Value
S=K=100
117.50
112.50
102.50
107.50
92.50
97.50
87.50
82.50
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100 Vanilla Call
Spot can take different paths to end at the same level
Payout does not depend on what path spot followed
Payout 7.50
S=K=100
117.50
112.50
102.50
107.50
92.50
97.50
87.50
82.50
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100 Call with Knock Out at 97.50
Extra condition for payout to occur applies
Smaller probability of payout
Payout is path dependant
= Premium discount
S=K=100
Outstrike = 97.50
117.50
112.50
102.50
107.50
92.50
97.50
87.50
82.50
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Knock-Out Options: Vanilla versus Knock-Out
Standard Call Option
StrikeOX
Spot
Knock Out Call Option
Strike
Spot
Strike
Spot
Standard Put Option
Strike OX
Spot
Knock Out Put Option
Barrier is placed in the OTM direction
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Knock Out option is 23% cheaper than a Plain Vanillaoption(1.3200 EUR Call, 3mths, costs 175 USD pips)
If the EURUSD rate touches once 1.2750 over the next 3
months, the option expires immediately
If the Outstrike of 1.2750 is not reached, the Knock Outoption behaves like a Standard option at expiration
Knock-Out Options: EURUSD (Hedger Example)
Assumption:
Strategy:
Analysis:
Customer needs to buy EUR and wants to protect himselffrom a adverse market move, e.g. a higher EUR againstUSD; spot CHF 1.3000 per 1 USD
Buy a 1.3200 USD Call / CHF Put, Outstrike 1.2750,expiration 3 months, amount USD 10m.
Premium 135 CHF pips (0.0135 USD per 1 EUR)
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If the OX is touched, the option and thus the protection ceases to exist.The hedge is no longer in place
But we get a chance to rehedge on a better level
either through a new Call (with OX) or by linking a Spot Buy Order to the OX initially
Summary: The Knock Out Call gives opportunities to rehedge at morefavourable levels, but monitoring and action is needed
Reasons for using a Knock Out Option Lower premium
Greater benefit from a move in spot (higher delta)
Option only exists when needed
Alternative names used: Up-and-Out
Down-and-Out
Knocked-Out... Is this good or bad?
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Kick-Out Options: Vanilla versus Kick-Out
Standard Call Option Standard Put Option
Kick Out Put Option
Strike
Spot
Strike OX
Spot
Kick Out Call Option
StrikeOX
Spot
Strike
Spot
Barrier is placed in the ITM direction
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Kick-Out Option: EURUSD (Investor Example)
Kick Out option is 60% cheaper than the plain vanillaoption(1.3200 EUR Call, 3mths, costs 175 USD pips)
If the EUR/USD rate rises at or above 1.4000 over the next3 months, the option expires immediately.If the outstrike of 1.4000 is never touched, the Kick Outoption behaves like a standard option at expiration
Assumption:
Strategy:
Analysis:
Customer anticipates a higher EUR against the USD towards1.4000 but not above and wants to profit from thismovement; Spot USD 1.3000 per 1 EUR
Buy a 1.3200 EUR Call/USD Put, Kick-Out 1.4000, expiration3 month, amount EUR 10m.
Premium 70 USD pips (0.0070 USD per 1 EUR)
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Long Kick-Out Option: EUR/USD (Investor Example)
-0.0200
0.0000
0.0200
0.0400
Strike
Outstrike
0.0600
-0.0400
SpotEURUSD
Exotic Option:
Kick Out Call Vanilla
Value atexpiration
1.3200 1.3300 1.3400 1.3500 1.37001.3600 1.3800
0.0800
1.4000
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Kick Out Option
Reasons for using a Kick Out Option
Very low Premium in exchange for potential give up
Expresses mildly bullish/bearish view
Benefit from high Volatility levels (Long Kick Out = Short Volatility)
Benefit from stable spot market (Long Kick Out = Earn Decay)
Alternative names used:
Reverse Knock-Out Option
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Kick-In Options: Vanilla versus Kick-In
Standard Call Option Standard Put Option
Kick In Put Option
Strike
Spot
IX
Kick In Call Option
Strike
Spot
Strike
Spot
Strike
Spot
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Kick-In Option: EURUSD
Kick In option is 8% less rich in premium than theplain vanilla option(1.3000 EUR Put, 2mth, receive 250 USD pips)
If the EURUSD rate falls at or below 1.2600 over thenext 3 months, the option becomes alive andbehaves like a standard option at expiration. If theinstrike of 1.2600 is never touched, the Kick In
option does not exist at the expiry date.
Assumption:
Strategy:
Analysis:
Customer anticipates a somewhat higher EUR againstthe USD in the next couple of weeks in a volatileenvironment. Spot USD 1.3000 per 1 EUR
Sell a 1.3000 EUR Put/USD Call, Kick-In 1.2600,expiration 3 month, amount EUR 10m.
Premium receive 230 USD pips (0.0230 USD per 1 EUR)
K k I O
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Kick In Option
Reasons for using a Kick In Option
Option buyer
Lower premium
Hedge appears only when needed
Fits view of a sharp move in spot
Option seller
Alternative to selling Standard Option
Collect premium with no obligation if Instrike is not breached
Often used in Risk Reversal Strategies
Alternative names used:
Reverse Knock-In Option
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Payout Options
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SECTION 2
Options that pay out an amount
depending on certain parameters
O T h O ti
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One Touch Option
What is a One Touch?
Pays a fixed amount if Trigger is touched during life of option
Quoted as % of Payout (Pay 20% - receive 100% if touched)
Reasons for using a One Touch Option
One Touch buyer:
Strong directional view
Fixed Risk-Reward
One Touch seller:
Alternative to short Standard Option in Risk Reversal
Limited downside
Alternative names used: Binary Option
Lock-In Option
American Digital Option
O T h E l
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One Touch Example
Right to receive fixed payout of 100,000 EUR
Pays out if spot reaches 1.3700 before expiration
The up front premium is 30% of payout (30,000 EUR)
Market Data Product Data
EURUSD Expiry: 3 month
Spot: 1.3000 Payout: 100,000 EUR
Trigger: 1.3700
Premium: 30% of payout
O T h
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One Touch
-30%
0%
30%
60%
90%
1.26 1.28 1.30 1.32 1.34 1.36 1.38
Spot at Expiration
%EU
RPayout
No Touch Option Double Lock Out
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No Touch Option Double Lock Out
What is a No Touch Option?
Pays a fixed amount if Trigger is NOT touched during life of option
Quoted as % of Payout (Pay 20% - receive 100% if not touched)
One Touch and No Touch prices are connected
Probability of NOT touching + Probability of touching = 100%
Price of One Touch + Price of No Touch = 100%
P/L of buying a One Touch Option is the same as selling the NoTouch Option with the same trigger
Pay outs can be @ touch or @ maturity
Double No Touch Option
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Double No Touch Option
What is a Double No Touch ?
The Double No Touch Option pays a pre-specified payout amount ifand only if Spot does not touch either of the two Outstrikes duringthe life of the option
Reasons for using a Double No Touch Option
Benefit from range bound spot market
Short Volatility with limited downside (premium)
Fixed Risk-Reward Earn time decay as time moves on
Alternative names used:
Double Lock-Out Option Range Bet
Range Binary
Double No Touch Option Example
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Double No Touch Option Example
Right to receive fixed payout of 100,000 USD.
Pays out if spot does not reach 99.0 or 106.0 before expiration.
Up front premium is 20% (20,000 USD)
Option will decay in your favour (from 20,000 to 100,000).
Market Data Product Data
USD/JPY Expiry 3 month
Spot: 103.00 Payout 100,000 USD
Outstrikes 99.0 & 106.0
Premium 20% of payout
Double No Touch
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Double No Touch
-40%
-20%
0%
20%
40%
60%
80%
100%
95 97 99 101 103 105 107 109 111
Spot at Expiration
%U
SDPayout
Digital options
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Fixed payout made at expiry if spot finishes ITM with respect tostrike
Also known as
Binary Options All-or-Nothing Options
Cash-or-Nothing
Asset-or-Nothing Options
Digital Call:
Digital Put
X
Pay-outat
expiry
Spot at expiry
X
Pay
-outat
e
xpiry
Spot at expiry
Digital options
Rule of thumb: Digital price = of OneTouch price
3m EURUSD 1.3700 Digital Call costs 17%
You pay EUR 17,000 today and get EUR100,000 at expiry if EURUSD trades at orabove 1.3700 at expiry.
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Multiple Assets and other Exotics
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SECTION 3
Multiple Assets
A
Ccy 1
Ccy 2
BC
D
Ccy 3
Multiple assets
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Multiple Assets
A
Ccy 1
Ccy 2
BC
D
Ccy 3
Multiple assets
The value of single asset optionsonly depends on the price of oneunderlying currency pair
The value of a multiple assetoption depends on more thanone currency pair
Basket Options
Quanto Options
Basket Options
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Basket Options
A basket option gives the holder the right to exchange onecurrency for a portfolio of currencies
A basket option can be designed so that the holder has the right
to buy all the basket currencies, sell all the basket currencies, orhave mixed cash flows against the base currency
Basket options are less expensive than the sum of the individual
vanilla options
The basket option discount to thevanillas is driven by the correlationbetween the basket of currenciesand the base currency
Managing a Portfolio of Currencies
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
-1 -0.5 0 0.5 1
Correlation
BasketPrice
[%USD]
Sum of premiumsof vanilla options
Premium ofbasket option
The Impact of Correlation on the Basket Price
Basket Options - Example
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Basket Options Example
A EUR based Asset Manager wants to hedge the following globalportfolio on 1yr time horizon:
The ATMS EUR Basket Value is 138.8m
Buy a Basket Put/ EUR Call, strike 138.8 for EUR 2.1m (1.5%) If at expiry the Fixed Currency amounts yield less than EUR 138.8m you
will exercise the option to sell the Basket Fixed Currency Amounts forEUR 138.8m
Sum of the vanillaoptions costs EUR 3.4m (2.4%)
Managing a Portfolio of Currencies
36%
30%
21%
13%
EUR
USD
GBP
JPY
local ccy FX in EUR in %
EUR 50 50 36%
USD 50 1.2200 41.0 30%
GBP20 0.6830 29.3 21%
JPY 2,500 134.85 18.5 13%
138.8
Basket Value
EUR 138.8mEUR 125m EUR 150m
PnL
Quanto Options
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Quanto Options
A Quanto option is an option where any payout at expiry isconverted to a third currency at an FX rate fixed on trade date.
Buyer has the right to exercise the option (just like a vanilla) but is
obligated to receive any payout in the quanto currency.
Example:
Client looking to take a position in EURJPY does not wish to have
currency exposure on the option payout With a vanilla option, if the EURJPY option is in-the-money at expiry,
the client would receive JPY payout
Would convert into USD at the prevailing USDJPY exchange rate
Payout could have been eroded by a weakening JPY vs. the USD
To eliminate this USDJPY risk, the client could purchase a EURJPYoption quantoed into USD, where the JPY payout is convertedinto USD at a USDJPY rate chosen at the time of trading
Hedges an exposure into a 3rd currency
Quanto Options - Example
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$.70m
$.80m
$.90m
$1.0m
$1.10m
$1.20m
$1.30m
85 90 95 100 105 110 115 120 125 130
QuantoNon-Quanto
6-month 135.00 strike EUR Call / JPY Put
The JPY payout can be converted into USD at a Quanto Strike of100.00 JPY per USD
Price:
Vanilla 135.00 EUR Call: 2.00%
Quanto 135.00 EUR Call
with 100 quanto strike: 2.30%
Payout: At expiry, EURJPY spot is at 145.00 and USDJPY spot is at 120.00
JPY Payout of EUR Call: JPY10 per EUR on 10m, or JPY 100m,converted to USD at the quanto strike of 100 gives a USD payout of$1m
If the USD-based client had used a vanilla option, their JPY optionpayout converted to USD at 120 would only have been $833k a 16%
reduction
Q p p
USD Payout at Expiry
Situation: A USD-based client wanting to play a bullish EURJPY view
Result: Client protected the USD value of option payout
Benefits of the quanto option
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q p
The attractive feature of a quanto option is that the JPY payoutcan be converted to USD at 100, regardless of
USDJPY exchange rate at expiry
JPY payout amount at expiry
If EURJPY were 140 at expiry, and the JPY payout had been JPY200m, that amount could still be converted to USD at the quantostrike of 100
A quanto option can be thought of as a quantity adjustingoption, providing currency protection on a notional not knownuntil expiry
Hedge an unknown notional the optionpayout in your non-home currency!
Vanilla or Exotic Options The choice is yours!
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p y
Whats your scope in the Foreign Exchange Market? e.g. are your a Hedger, an Investor or a Yield Enhancer?
What are your expectations?
Spot-Market moves up/down/sideways?
Volatility moves up/down/sideways?
Timing? (Windows)
Whats your risk appetite?
Long versus short position or a combination thereof?
Desired leverage factor
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