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 other situations, can be solved with these tidy packages. Here we'll go over a few different kinds of exotic options and how they might be used in your portfolio.
A binary, or digital, option is defined by its unique payout method. Unlike traditional call options, in which final payouts increase incrementally with each rise in the underlying assets price above the strike, this option provides the buyer with a finite lump sum at that point and beyond. Inversely, with the buyer of a binary put option, the finite lump sum payout is received by the buyer if the asset closes below the stated strike price.
If you're having trouble imagining this scenario, let's look at an example. Suppose you purchase a binary call option at a premium of $5.50, with a stated payout of $10 on XYZ at the strike price of $50. Let's fast forward: it's now the expiry date, and XYZ is at $50.25. Because the underlying asset, XYZ, is above the strike price of $50, you receive a lump sum payout of $10. Conversely, if XYZ is at $49, you will not receive anything. If XYZ is priced at $120 on the expiration date, your payout is still $10.
In this example, the fictional XYZ ticker has an equity as the underlying asset. You will find, however, that most traded binary options are based on the outcomes of events rather than equities. Things like the level of the Consumer Price Index or the value of Gross Domestic Product on a specific date are usually the underlyings of the option. As such, you'll find early exercise impossible because the underlying conditions will not have been met.
What's roughly halfway between the United States and Europe? It's a tiny place called Bermuda. If you're familiar with options, you'll know there's a difference between what are called American options and European options. American options can be exercised anytime between their purchase and the expiry date. European options, on the other hand, can only be exercised at the expiry date. It makes sense then that Bermuda options will lie somewhere in between.
Bermuda options can be exercised at the expiry date as well as certain specified dates in between the creation and expiration of the option's life. This style of option may provide the writer with more control over when the option is exercised and provides the buyer with a slightly less expensive alternative to an American option without the restrictions of a European option (American options demand a slightly larger premium due to their "anytime" exercise feature).
Quantity-adjusting options, also called quanto options for short, expose the buyer to foreign assets but provide the safety of a fixed exchange rate in the buyer's home currency. This option is great for an investor looking to gain exposure in foreign markets, but who may be worried about how exchange rates will settle when it comes time to settle the option.
For example, a French investor looking at Brazil may find a favorable economic situation on the horizon and decide to put some portion of allocated capital in the BOVESPA Index, which represents Brazil's largest stock exchange. The problem is, the French investor is a little worried about how the exchange rate for the euro and Brazilian real might settle in the interim. The solution for this French investor is to buy a quantity-adjusting call option on the BOVESPA denominated in euros. This solution provides the investor with exposure to the BOVESPA and lets the payout remain denominated in euros.
As a two-in-one package, this option will inherently demand an additional premium that is above and beyond what a traditional call option would require. This provides quantity-adjusting option writers with an additional premium if they are willing to take on this additional risk of currency exchange as well.
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 priced as easily, 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 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.
The Bottom Line
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.