Exotic Option

Exotic options, as the name suggests, are more complex variations of the simple vanilla options, in terms of trigger points, payoff determination, expiry, underlying assets, and other such features of the same, designed suiting to the needs of the partaking investors and therefore sell through the Over-the-Counter (OTC) market.

Exotic options are unique derivative contracts explicitly designed for the contracting parties to hedge a particular risk or speculate on the expectations of a highly specialized underlying asset. The risk is higher, and therefore, the reward is higher too. However, the chances of unfair practices are more significant in the case of exotic options; therefore, these transactions are under the close watch of regulators.

• Exotic options are complex variations of standard vanilla options, differing in trigger points, payoff calculation, expiration, underlying assets, and other features. These options are typically traded through the over-the-counter (OTC) market to cater to specific investor requirements.
• Various types of options exhibit unique attributes, such as quanto, binary, lookback, Asian, and barrier options. Contrary to common misconception, their names are not linked to Asia or horse racing origins.
• Exotic options serve as derivative contracts utilized for speculation or hedging specialized assets. Due to the potential for unethical practices, these options attract scrutiny. 

An exotic option is a kind of derivative contact used in the financial market which is quite different form the standard or vanilla options. They have complex features and are not so widely used like standard options. These options are customised to meet the requirements of trading and risk management. sophisticated and established institutions and traders use this technique.  

At times it is suggested that these options are so-called because they have been inspired by the ‘Exotic’ horse race bets or because some have emerged in Asian countries, which are considered ‘Exotic’ in the west. However, it is best to say that they are so-called because of their lesser-known features that are out of the ordinary.

However, they are mainly used for hedging purpose to protect the investor from some particular type of risk. Sometimes, using these options, certain payoff structures are custom made so as to meet some specific business or investment objective. Due to some of the special features that they have, pricing can become complex. For this reason, they are not used frequently.

Let us look at some important types of the same, as given below:

#1 - Quanto Options

• These are options, with the underlying being one currency and the payoff being another. A name is a short form of Quantity adjusting option. It is purchased due to an expectation that the underlying currency might appreciate in terms of a third currency; however, the domestic currency of the long party might depreciate against the underlying currency.
• For example, the Mexican investor believes that the USD will appreciate against the JPY, but the MXN peso will depreciate against the USD, so the gains from the USD might reduce due to loss from MXN. Therefore the payoff will be in MXN, and the profit determination will be in the USD/JPY currency pair. These are cash-settled options

#2 - Binary Options

The exotic option pricing options can have only two outcomes, a predetermined payoff if the option is in the money or absolutely nothing if out of the money and therefore these are so named.  These involve a simple high-low prediction, such as whether or not the underlying asset will reach a certain price. If it does, the short pays the long, and if it doesn’t, the short forfeits the initial pot. Such options are more like wagers.

#3 - Lookback Options

In this case, the long can select the highest price of the asset during the option's life and use it for the profit and payoff determination in the case of a call-like option and, similarly, select the lowest price if it is a put-like option.

#4 - Asian Options

Like the Lookback option, the payoff is determined by taking the average of the underlying prices seen during the lifetime, unlike the American Option or European options, which use the Spot price at the expiry.

#5 - Barrier Options

These need activation triggers. There is a predetermined price level; if the underlying reaches this point even once during the option's lifetime, they get activated. After they are activated, they can be exercised if favorable to the long party; otherwise, they expire worthlessly. There are many more; however, developing a comprehensive list is not a mean task considering that newer contracts emerge frequently.

As such contracts are customized, there can't be a complete laundry list of the features because exotic option strategies with newer features emerge now and then. However, a few of the features can be elaborated upon to get the idea of the same:

1. Can have Multiple Underlying: An exotic option may be tied to multiple underlying assets, and therefore their profitability will depend on the performance of all these assets and their performance
2. Payoff Determination: Many different kinds of options have varied payoff calculation methods. For example, an option can be customized to use the maximum value of the asset during the option's life to be compared to the strike price for payoff and profit determination instead of the spot price at the time of expiry
3. Settlement Methodology: At times, the options may require physical settlement through the delivery of the underlying asset, or it may be settled through netting the cash flows dependent on the calculation methodology.
4. Averaging – The exotic option pricing have or use the averaging mechanism where the payout is is based on the underlying asset’s average price.
5. Multiple exercise dates – This option allows the holder to exercise the option at multiple dates, which is very different from the standard options with only one expiration date.
6. Strict momitoring – It may require a strict and continuous monitoring and if required, adjustments are made because of their complex features.

However, it is to be noted that this kind of option can have varied and complex features. There may be newly designed exotic options that are more innovative and introduced in the financial market for attracting more investors who require a higher level of strategic risk management techniques. But it is important to understand the risks and regulations associated with exotic option strategies.

#1 - Higher Counterparty Risk

The stock exchange acts as a clearinghouse and the counterparty to all the transactions. However, for this to happen, the contracts need to be standardized, which is not the case with Exotic options. As they are customized, these are part of the OTC market, which has little investor protection, and it all boils down to the negotiations and trust between the parties. This increases the counterparty risks

#2 - Regulations

Due to the nature of these options, many countries have a highly regulated framework against not allowing some of these. Even if these are allowed, they have resulted in many fraudulent activities. So, most countries refrain from continued trade of these contracts. One such option is the Binary option, which has been considered a highly risk-prone gambling instrument. Many scams are being tracked by the US and Europe related to such options.

#3 - Complexity

Due to their non-standardized features, the payoff and profit calculations of exotic option trading become complex. This leads to a requirement of greater due diligence on the part of all the parties entering into the contract to understand what they are getting into clearly.

#4 - Lack of Disclosure

As these are mostly traded in the OTC market, the disclosure requirements are very less, and therefore there are greater possibilities of illegal activities undertaken as part of such contracts. According to the FBI's stats, the scam can amount to USD 10 billion annually in the case of binary options alone.

As there can be several types of exotic options, there can be several examples; one such example can be of Barrier option:

• Let’s assume that the underlying is the exchange rate between USD and EUR, and the activation exchange rate is USD 2 per EUR. So if it is a knock-in barrier put option on EUR, it will get activated only if the exchange mentioned above is reached during the option's lifetime.  Suppose that the strike rate is USD 1.5 per EUR, and at the expiry, the Spot is USD 1.8 per EUR.
• The option will exist only if, during the lifetime, the exchange rate reaches USD 2 per EUR, and then the long will receive a payoff of 1.8-1.5 = USD 0.3 per EUR. If the activation rate has not been reached, the option will not lead to any payoff. The opposite is a knock-out barrier option, which gets extinguished if the deactivation rate is reached; it limits the loss for the short and the gain for the long.

Both the type of option contacts mentioned above differ in many ways. Let us study the differences in detail.

1. Cost: Exotic options cost less if they are disadvantageous to the long party. For example, the above-explained barrier option will cost less as it limits the loss of short and the gain of long. They may cost more if they are advantageous to the long, for example, a Lookback option.
2. Trading: Vanilla options trade on an exchange while some of the Exotic options can trade on the exchange; most of such contracts are OTC, due to which the risk associated with the counterparty not fulfilling the contract is higher for exotic option trading.
3. Underlying: They have a highly varied set of underlying, such as commodities, or highly customized assets, while vanilla options have standardized underlying assets such as stocks and bonds.
4. Calculation: Calculation methodology is more complex in the case of exotic options as compared to vanilla options.
5. Liquidity – The former is less liquid because they are less standardized. They are designed to suit some particular needs and so trading in them is complex. But the latter is more liquid because of their standardized nature. It is easy to enter or exit positions using the vanilla option. Risk and return – The vanilla options have a clear and more specific risk and return profiles. The losses are limited to the premium paid and profits are unlimited or is limited to the value of strike price minus the premium amount. But the exotic ones have more complex return and risk profiles. They offer better possibilities or hedging but sometimes they can also lead to very high risk and unlimited loses.
6. Uses – The former is designed or customised to meet some special risk management objectives or high-profile institutional investors, but the latter is used for standard hedging, speculation or risk management purposes.
7. Flexibility – The former is less flexible than the latter. The investors find vanilla options more flexible and tgus, they are widely used in the financial market.

The above points highlight the fundamental differences between the two types of options given above.

This has been a guide to what is Exotic Option. We explain the types along with examples, features, barriers and differences with vanilla option. You can learn more about it from the following articles –

• Sell Through Rate
• Knock-Out Option
• Disclosure Statement
• Option Chain
• Put Option Payoff