All about Exotic options
This article requires a bit of background reading on what options are so it is advisable to read our previous article. Options are a type of derivative. Exotic options are the most complex out of all the option types. They are not very pleasing to the eye due to their mathematical complexity. They are mainly traded over the counter (OTC). However, due to their popularity they are appearing on other exchanges which have added to their growth. The reason why they are called exotic is because they are catered for the client’s needs. They are unique, but having a tailored option comes at a price. Exotic options are more expensive than plain vanilla options.
Since these options are tailored it becomes harder (external factors) to determine the rate of return. In addition, complex mathematics also makes it difficult to price options. It can therefore be very tedious for financial intermediaries to measure the rate of return on exotic options.
Exotic options are mainly used in the FX market; this is used by investors to hedge the market. We will be looking at Binary options and Bermudan options which are a type of exotic option.
Bermuda is between America and Europe and this is the reason why these options are in the middle and hence you can assume that the option lies in between American and European options. This means that Bermudan options can be exercised at specified times (which is usually written in the contract) and on the date of the expiry. This entitles the buyer of the option to exercise the option once. In addition, it is less expensive than an American option.
Binary options are sometimes called digital options and they are the most popular type of exotic options. We shall explain why they are called digital options. Binary in computing language is a string of data that consists of ones and zeros of which there are two outcomes, thus like flipping a coin there is a 50% chance that the underlying assets price is higher/lower than the exercise price on expiry. This type of exotic option does have some similarity to plain vanilla options, which is that put options and call options supplement them.
There are two types of binary options; cash-or-nothing and asset-or-nothing options. These are usually European style options. Cash-or-nothing options usually pay a fixed rate of return if you exercise your option when it expires. Asset-or-nothing options give a return which is determined by the value of the security.
It is always advisable not to stride in to complex derivatives unless you are sure that you understand the risks involved. Derivatives are the most complex financial instruments and exotic products are probably the most complex form of derivatives.