Exotic options are like regular options except that they have unique features that make them complex. These unique features adapt themselves to situations that might otherwise require some rather crafty financial engineering. Situations requiring an all-or-nothing style hedge, situations where an investor faces exchange rate and price risk, as well as many others situations, can be solved with these tidy packages.
Benefits vs. Drawbacks
When it comes to pricing options, traditional options can be priced using the Black-Scholes option pricing formula. Exotic options can’t be as easily priced, at least not with a measure as widely accepted as the Black-Scholes. This can serve as a benefit as well as a drawback, as the inherent mispricing of exotic options may either work for or against the investor.
Another dilemma is the availability and the risk of liquidity one takes on with exotic options. While some exotic options have fairly active markets (the binary option) others are mostly thinly traded over-the-counter instruments. Some might even be pure dual-party transactions, with no liquidity, as names are stated in the underlying contract.
Conclusion
Exotic options have unique underlying conditions that make them a good fit for high-level active portfolio management and situation-specific solutions. Complex pricing of these derivatives may give rise to arbitrage, which can provide great opportunity to sophisticated quantitative investors. There are many varieties of exotic options, too numerous to describe here, but if you know how to use them, you can learn to profit from nearly any trading scenario.
“Exotic” Options with Standard Exercise Styles
- A cross option (or composite option) is an option on some underlying in one currency with a strike denominated in another currency.
- A quanto option is a cross option in which the exchange rate is fixed at the outset of the trade, typically at 1. An exchange option is the right to exchange one asset for another.
- A basket option is an option on the weighted average of several underlyings
- A rainbow option is a basket option where the weightings depend on the final performances of the components. A common special case is an option on the worst-performing of several stocks.
- A Low Exercise Price Option (LEPO) is a European style call option with a low exercise price of $0.01.