What is an exotic option?
An exotic option is a complex option in the financial world with different contract specifications.
All variables that have been standardized for standard option contracts (the so-called vanilla options) can be adjusted for exotic options. For instance:
- Time of exercise. For example, it can be agreed that an option can only be exercised during certain periods.
- Underlying value. Instead of one underlying asset (such as a share or an index), the option can relate to a combined basket of shares.
- Knock-out. An option may lapse if an agreed price level is tapped, the so – called knock-out level.
- Knock-in. An option can only be exercised if a pre-agreed price level has been tapped.
- Other currencies. An option on a share can be settled in a currency other than that in which the share is quoted with complex conditions.
Exotic options are not traded on the normal exchange, but only in the over-the-counter market (OTC). Only the big investment banks issue prices in exotic options. The deviating contract specifications entail difficulties for the banks to hedge the risks.
The investors in the exotic options can be divided into two categories. The structured products for private individuals such as click funds and guarantee notes usually use exotic options. In addition, companies can cover their risks in the area of currencies and commodities in a precise way.
Exotic option styles
With normal vanilla options, there are two types of exercise. This distinction has nothing to do with the place where they are traded; all normal stock options in Europe are American style.
European style – can only be exercised at one time, namely at the end of the term.
American style – can be exercised during the entire term.
The exotic options have a number of variations on the above two species.
Bermudan style – can only be exercised during certain periods during the term. The name is derived with a nod from the Bermuda Islands, which lie between Europe and America.
Canarian style – can only be exercised during certain intervals during the term, but these intervals only start after a period of, for example, a year. The name is again with a wink derived from the Canary Islands because they also lie between America and Europe, only more on the European side.
Types of exotic options
Everything is possible with exotic options because they are custom made. In practice, however, most exotic options are a combination of a limited number of species.
- Digital option
- Lookback option
- Barrier option
- Chooser option
- Quanto option
- Bermuda option
- Asian option
- Himalaya option