Investing in exotic options

Abstract

In Chap. 14, we introduced the pricing of plain vanilla call and put options on dividend paying and nondividend paying stocks. In this chapter we introduce the pricing of "exotic options." This chapter has the following objectives: • Introduce different types of exotic options • Discuss the pricing of Barrier, Look back, Binary, Asian, and spread options Exotic options are a class of derivative products, which allow the buyer (or seller) of the option to capture return profiles, which are more specific to their expectations or needs. Compared to plain vanilla options and stocks, exotics can have additional features or characteristics that make them more attractive in terms of both risk and reward. Although the options market has existed for hundreds of years, it was not until the late 1970s when the BlackScholes model (Black and Scholes 1973) was published that practitioners began to trade more extensively in derivatives. Exotic equity options began trading soon after but gained much less interest through most of the 1970s, and vanilla options and warrants were the main products traded in the markets. It was not until the 1980s and, subsequently, the introduction of overthe- counter (OTC) markets in the 1990s that interest in exotic options picked up as investors sought new ways to generate returns and help to reduce risk in portfolios. Even though interest in options has increased, the growth of options and derivatives, particularly during the 1990s, has been held back by the portrayal of derivatives as dangerous instruments, largely due to an association with large trading losses in recent history. A number of these cases stand out: Metallgesellschaft AG's losses in oil derivatives in late 1993, the collapse of Long-Term Capital Management in 1994, Enron's bankruptcy in 2001, and, more recently, the collapse of hedge fund Amaranth Advisors LLC after losses exceeding US $6 billion. In most of these cases, the losses can be attributed to excessive leverage, improper risk management controls, and a general lack of understanding of these products. Nonetheless, the market for derivative products continues to grow at a phenomenal rate, leading to a demand from a wider range of investor classes, which in turn has led to the greater need for transparency and knowledge of both vanilla and exotic-type contracts. This chapter introduces some of the concepts behind exotic options and their practical uses. Exhibit 15.1 defines the standard notation used throughout. © 2009 Springer-Verlag Berlin Heidelberg.