What are Exotic Options?
Exotic options are the classes of option contracts with structures and features that are different from plain-vanilla options (e.g., American or European options). Exotic options are different from regular options in their expiration dates, exercise prices, payoffs, and underlying assets. All the features make the valuation of exotic options more sophisticated relative to the valuation of plain-vanilla options. Below is a list of various Exotic Options.
Explanation of Exotic Options
The more advanced and complex features of exotic options allow their holders to realize substantial returns. Also, the exotic options’ various features make them perfect for hedging and risk management.
Exotic options are products of financial engineering, which is concerned with the creation of new securities and developing suitable pricing techniques. Finance professionals who work on the development of new types of securities are called financial engineers.
Types of Exotic Options
The most common types of exotic options include the following:
1. Asian options
The Asian option is one of the most commonly encountered types of exotic options. They are option contracts whose payoffs are determined by the average price of the underlying security over several predetermined periods of time.
2. Barrier options
The main feature of barrier exotic options is that the contracts become activated only if the price of the underlying asset reaches a predetermined level.
3. Basket options
Basket options are based on several underlying assets. The payoff of a basket option is essentially the weighted average of all underlying assets. Note that the weights of the underlying assets are not always equal.
4. Bermuda options
These are a combination of American and European options. Similar to European options, Bermuda options can be exercised at the date of their expiration. At the same time, these exotic options are also exercisable at predetermined dates between the purchase and expiration dates.
5. Binary options
Binary options are also known as digital options. The options guarantee the payoff based on the occurrence of a certain event. If the event has occurred, the payoff is a fixed amount or a predetermined asset. Conversely, if the event has not occurred, the payoff is nothing. In other words, binary options provide only all-or-nothing payoffs.
6. Chooser options
Chooser exotic options provide the holder with the right to decide whether the purchased options are calls or puts. Note that the decision can be made only at a fixed date prior to the expiration of the contracts.
7. Compound options
Compound options (also known as split-fee options) are essentially an option on an option. The final payoff of this option depends on the payoff of another option. Due to this reason, compound options have two expiration dates and two strike prices.
8. Extendible options
Extendible option contracts provide the right to postpone their expiration dates. For example, the holder-extendible options allow a purchaser extending their options by a predetermined amount of time if the options are out-of-money. Conversely, the writer-extendible options provide similar rights to a writer (issuer) of options.
9. Lookback options
Unlike other types of options, lookback options initially do not have a specified exercise price. However, on the maturity date, the holder of lookback options has the right to select the most favorable strike price among the prices that have occurred during the lifetime of the options.
10. Spread options
The payoff of a spread option depends on the difference between the prices of two underlying assets.
11. Range options
Range options are also distinguished by their final payoff. The final payoff of range exotic options is determined as the spread between maximum and minimum prices of the underlying asset during the lifetime of the options.
Thank you for reading CFI’s guide to exotic options. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: