Exotic Options

An Exotic Option is a type of option that differs from common American or European options in terms of the "underlying asset or the calculation of how or when the investor receives a certain payoff."(Investopedia.com) Asian options are generally more complex than standard vanilla options and generally trade in the OTC markets. Three of the most well known types of Exotic Options are: Asian Options, Barrier Options, and Lookback Options.

Asian options are options in which the underlying variable is the average price over a specified period of time. Since you are using the average price, Asian options have a lower volatility, and are cheaper than European or American Options. Although they are not are trading on any exchange, they are commonly traded in the OTC market for currencies and commodity products which have low trading volumes. Asian options are the most useful when an individual is using them hedge against events that take place over a certain period of time. For example, using an Asian option to hedge against the exchange rate would be appropriate if a country knew they were to receive a steady cash flow of another currency over a longer period of time. Asian Options get their name because, "they were originally used in 1987 when Banker's Trust Tokyo office used them for pricing average options on crude oil contracts; and hence the name 'Asian' option." (http://www.globalderivatives.com) Asian options are issued either in the European version in which case they can be exercised only on expiration date or in the American version where they could be exercised any time prior to expiration.There are three different types of Asian Options named for the different averages used in them: arithmetic average Asians, geometric average Asians. Also, one can average them using the weighted average basis, in which a specified weight is added to each stock being averaged. This is useful when the sample population is skewed.

Asian Options are great investment opportunities for investors due to their minimal risk. It is easy for an investor to determine if Asian Options are a good investment and fits the goals of the investor. For example, if the underlying asset appears to be more volatile than an investor feels comfortable with, the process of calculation that goes into Asian options will make that clear, and allow the investor to seek opportunities elsewhere. On the other hand, the investors who specialize in riskier instruments will conclude that Asian options do not have the potential to get the returns one may be seeking and these individuals can move on to riskier investments with that potentially have a higher rate of return. Asian options are a great investment for many individual and corporate investors. Asian Options are for investors that are looking for an equitable amount of risk matched with a reasonable return; this is an option that continues to be attractive to many people who want to be a little creative with their investments while still avoiding high speculative deals.

One of the best ways to understand an Asian Option is by comparing it to a regular plain vanilla option. (European Call Option) If we are the holder of a plain vanilla option, we hope to see the underlying assets price increase and rise above the strike price so we can exercise the European Call Option at expiration. Our payoff is the difference between the spot price of the asset on expiration and the strike price. In a plain vanilla option, we use the spot price at the time of exercise. One of the disadvantages of the vanilla option is that we are exposed to the temporal volatility of that spot price. The values on the exercise date are more random, meaning there is more basis risk. This is where Asian Options are useful. There are twelve different variations of the Asian Options; one of them being an average price call. In the case of an average price call, when we exercise, it's not the difference between the spot price and the strike price but rather the difference between the average spot price and strike price. There are two benefits to this: since we are using the average of the spot price instead of the point in time value, the Asian option is going to be less volatile than a typical plain vanilla option. Less volatility means less value and it will cost us less to purchase the Asian Option since it has it has a lower premium. The other benefit is that it is easier to delta hedge the option. As the option approaches expiration, or as the maturity shortens, the delta on the option approaches zero. The average value used can either be arithmetic, geometric, or a weighted average. In the example I used, I used an average Price Call, we can also use an average strike call. In this case, instead of averaging the spot price, we can average the strike price. The payoff would be the spot price of the underlying asset minus the average strike price. In addition to being able to do this for calls, one can also take the average strike price and put prices.

One of the biggest benefits of Asian Options is that compared to other options, there is no universal way of evaluating them. Practitioners of Asian options enjoy the choice of many models for approximations that are accurate and easy to use. Some examples of different valuation methods are: Geometric Closed Form, Arithmetic Rate Approximation, Binomial Method & Trinomial Trees, Finite Differences Method, and Monte Carlo Simulation. Asian options are popular in markets where this is little trading activity in a market because of a lack of buy or sell orders to drive up the volume. Traders of Asian Option also like Asian Options like it because it is harder to manipulate values closer to expiration than the values on expiration of ordinary options. They are also attractive to some set of investors wanting to avoid risk unless adequately compensated for it.Used by many Financial Institutions for Risk Management purposes.

Another type of Exotic Options is Barrier Options. Barrier Options are often traded on the over-the-counter market. Barrier Options are one type of financial instrument in which the payoff depends on the stock price of a particular asset reaching above or staying below the barrier level until maturity. Barrier Options have different qualities than standard vanilla options. They are becoming attractive for investors because they are less costly compared to the price paid for regular options. As the calculation for Barrier is to be made for a future time the functions are calculated lognormal as well as probability distributed.

Sub-categories in Barrier Options

Barrier Options have numerous sub-categories of options included in them. Two of the most important options are knock-in option and knock-out option. There are four sub-categories included in knock-in and knock-out options; they are