Financial Derivatives and Risk Management: Exotic Options: Elisa Alòs and Raúl Merino

Financial Derivatives and Risk Management:
Exotic Options
Elisa Alòs and Raúl Merino

Universitat Pompeu Fabra
Barcelona, 2020
Elisa Alòs and Raú Merino (UPF) UPF 1 / 47

Contents
1 What is an exotic option ?
2 Barrier options
3 Non-standard American options
4 Binary options
5 Gap options
6 Forward start options
7 Compound options
8 Options ’as you like it’
9 Lookback options
10 Asian options
11 Options depending on more than one underlying
12 Options on the volatility
Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Exotic options are ’non-standard’ options, where we understand that
’standard’ options are European and American calls and puts where
the underlying is a market index, a stock or a currency.
Despite their name (’exotic’), they are commonly used in several

applications. For example, the next Figure we can see the quotes of
options on the difference (’spread’) between the prices of two kinds of
oil (WTI and Brent) :

Figure – Spread options

Let us introduce the basic types of exotic options.

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Barrier options
A barrier option is an option whose final payoff depends on the price

of the underying reaching a certain level (barrier).

For example :
Knock-out options : they go out of existence if the asset
reaches the barrier. In particular :
I down-and-out : the barrier level is less than the price of the
underlying
I up-and-out : the barrier level is higher than the price of the
underlying
Figure – The option is exercised if and only if the asset price

remains in the green area

Knock-in options : they come into existence if the asset
reaches the barrier. In particular :
I down-and-in : the barrier level is less than the price of the
underlying
I up-and-in : the barrier level is higher than the price of the
underlying
Figure – The option is exercised if and only if the asset price arrives at
some moment at the green area

Example
Consider the following data corresponding to Starbucks Corporation
stocks.
Assume we had call barrier (knock-out and knock-in) options starting

in May 2018, with strike equal to 45, with maturity Aug 31, and with
different barriers (50 and 65 USD).
Which ones of these options were exercised at maturity ?

Example (Cont)
Figure – Starbucks stocks

Example (Cont)
The barrier 50 is reached. Then, a knock-out option (down and
out) with this barrier is not exercised, while a knock-in option
(down-and-in) is exercised.
The barrier 65 is not reached. Then, a knock-out option (up and
out) with this barrier is exercised, while a knock-in option
(up-and-in) is not exercised.

Properties of barrier options
Some interesting properties of barrier options are the following
The payoff of a call (ST − K )+ can be writen as the sum of the
payoffs of two barrier options. In particular it can be writen as
the sum of the payoffs of
I a knock-out option with strike K and some barrier A, and
I a knock-in option with the same strike and barrier.
Figure – knock-out+knock in=vanilla

Barrier options are path-dependent derivatives : their payoff does
not depend only on the final value of S, but on the whole path
of S, from today to maturity time.

The payoff of a barrier option always less or equal than the price
of the corresponding vanilla option. Then, it is a cheaper
product. This can be interesting in applications, as we will see in
the following example.

Example (Adapted from https ://www.home.saxo/-
/media/documents/factsheet/fx-barrier-options-
factsheet.pdf
)
Assume the spot EURUSD is trading at 1.1150.
We expect this EURUSD to trade below 1.0800 within two months.
In this context, it can be interesting to buy a vanilla put option with

strike 1.0800, that has a cost of 55 USD pips (1 USD pip=0.01
USD).
But now, let us see how to improve this strategy using barrier
options. Let us consider 2 situations :

Example
Figure – Volatility and barrier options

Example
If the EURUSD is volatile and we consider it will reach the
barrier 1.1300 before maturity, it could be interesting to consider
a knock-in at 1.1300. Such an option costs 19 USD pips,
cheaper than the corresponding vanilla put.
If the EURUSD is not volatile and we think the price will remain
below 1.1300, we can buy a knock-out at 1.1300. Such an option
costs 43 USD pips, cheaper than the corresponding vanilla put.

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Non-standard American options
Some non-standard American options include :

Bermudan options They can be exercised at some fixed times
before maturity.
Options that can be exercised only during part of life of the
option (with an initial lock out period, for example)
American options where the strike changes over the life.

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Binary options
Binary options are options where the payoff is either some fixed
monetary amount or nothing at all.
cash-or-nothing calls pay a certain ammount Q if ST > K ,
otherwise pays nothing.
asset-or-nothing calls pay ST if ST > K , otherwise pays
nothing.
cash-or-nothing puts pay a certain ammount Q if ST < K ,
otherwise pays nothing.
asset-or-nothing puts pay ST if ST < K , otherwise pays
nothing.

As an example, we can see the payoff of a cash-or nothing call with
Q = 20 and an asset-or-nothing call with strike K = 100
Figure – Binary options

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Gap options
A Gap call option is a European option that pays ST − K1 if

ST > K2 , where K1 and K2 are different.
Similarly, A Gap put option is a European option that pays K1 − ST if

ST < K2 , where K1 and K2 are different.

Figure – Gap call with K1 = 100, K2 = 120 and Gap put with
K1 = 140, K2 = 120

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Forward start options
A forward start option is an European option whose strike is fixed at

some moment (that we will denote T1 ) between today and maturity
time. Usually, this strike is a function of ST1 . For example, the payoff
of a forward call is writen as
max(ST − cST1 , 0),
were c is a constant that we fix in the contract. Several times, c is

assumed to be equal 1.

In this type of options, the final payoff depends on the price S of the
underlying at two moments T1 and T . Notice that, after the moment
T1 , the option is a vanilla option with strike equal to cST1 . If c = 1,
this is an ATM option.

Example
Consider the following chart corresponding to NETFLIX prices.
Figure – Netflix stocks

Example (Cont.)
Assume today is June 1st 2019 and we consider a forward start call
where c = 1, T1 is July 1st 2019 and maturity (T) is November 1st.
This means that, after T1 , we have a vanilla call with strike
ST1 = 374.60.
A sequence of forward start options is called a cliquet. When one

forward option is exercised, another vanilla option starts, with the
new strike option depending on ST .

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Compound options
Compound options are those that have, as an underlying, another

option.
As the price of an option is usually smaller than the price of the

underlying, the price of a compound option is usually very small.

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Options ’as you like it’
In this type of options, there is a moment before maturity (that we

will denote by T1 ), where we can decide if our option is a call or a
put.

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Lookback options
In lookback options, the payoff depends on the optimal (maximum or

minimum) underlying asset’s price occurring over the life of the
option.

For example
A floating lookback call pays ST − Smin at maturity T , where
Smin denotes the minimum of S during the life of the option.
A floating lookback put pays Smax − ST , where Smax denotes
the minimum of S during the life of the option.
A fixed lookback call pays max(Smax − K , 0), where K is some
fixed strike.
A fixed lookback put pays max(K − Smin , 0), where K is some
fixed strike.
Notice that lookback options are path-dependent options. Moreover,
in floating lookback options, the strike is computed at maturity.

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Asian options
Asian options are European options whose payoff depends on the

average Save (usually, arithmetic average) price of the underlying
during the life of the option.

Some examples include :
Average price calls : the payoff is max(Save − K , 0), for some
strike K .
Average price puts : the payoff is max(K − Save , 0), for some
strike K .
Average strike calls : the payoff is max(ST − Save , 0).
Average strike puts : the payoff is max(Save − ST , 0).

As the volatility of the average is less than the volatility of the
underlying asset, Asian options are, in general, cheaper that the
corresponding vanillas.
One of the main advantages of Asian option is that they reduce the
risk of market manipulation of the underlying at maturity. Clearly,
they are path dependent options.

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Options depending on more than one underlying
Some options depend not only on one underlying, but on 2, 3, etc.
For example, exchange options pay max(ST1 − ST2 , 0) at maturity,

where S 1 and S 2 , denote the prices of two underlyings.
In a similar way, spread options pay max(ST1 − ST2 − K , 0), for some
fixed K . Spread options are very common in commodity markets (as
energy markets).
Nowadays, 3-assets spread options, that pay a payoff of the type

max(ST1 − ST2 − ST3 − K , 0) are becoming more relevant. An option
whose underlying depends on a set of assets is called a basket
option.

Contents
2 Barrier options
4 Binary options
5 Gap options
7 Compound options
9 Lookback options
10 Asian options
Options on the volatility
As markets become more complex, it becomes interesting to consider
options on the volatility. But the ’volatility’ is not a traded asset. One
way to measure the volatility is the VIX (volatility index of the
CBOE). Options on the VIX allow market participants to hedge
portfolio volatility risk.
Figure – VIX index (CBOE, 2019)

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Financial Derivatives and Risk Management:

Elisa Alòs and Raúl Merino

Elisa Alòs and Raú Merino (UPF) UPF 1 / 47

Despite their name (’exotic’), they are commonly used in several

Elisa Alòs and Raú Merino (UPF) UPF 4 / 47

Elisa Alòs and Raú Merino (UPF) UPF 5 / 47

Elisa Alòs and Raú Merino (UPF) UPF 6 / 47

A barrier option is an option whose final payoff depends on the price

Elisa Alòs and Raú Merino (UPF) UPF 8 / 47

Figure – The option is exercised if and only if the asset price

Elisa Alòs and Raú Merino (UPF) UPF 9 / 47

Elisa Alòs and Raú Merino (UPF) UPF 10 / 47

Assume we had call barrier (knock-out and knock-in) options starting

Which ones of these options were exercised at maturity ?

Elisa Alòs and Raú Merino (UPF) UPF 11 / 47

Figure – Starbucks stocks

Elisa Alòs and Raú Merino (UPF) UPF 12 / 47

Elisa Alòs and Raú Merino (UPF) UPF 13 / 47

Figure – knock-out+knock in=vanilla

Elisa Alòs and Raú Merino (UPF) UPF 14 / 47

Elisa Alòs and Raú Merino (UPF) UPF 15 / 47

Elisa Alòs and Raú Merino (UPF) UPF 16 / 47

We expect this EURUSD to trade below 1.0800 within two months.

In this context, it can be interesting to buy a vanilla put option with

Elisa Alòs and Raú Merino (UPF) UPF 17 / 47

Figure – Volatility and barrier options

Elisa Alòs and Raú Merino (UPF) UPF 18 / 47

Elisa Alòs and Raú Merino (UPF) UPF 19 / 47

Some non-standard American options include :

Elisa Alòs and Raú Merino (UPF) UPF 21 / 47

Elisa Alòs and Raú Merino (UPF) UPF 23 / 47

Figure – Binary options

A Gap call option is a European option that pays ST − K1 if

Similarly, A Gap put option is a European option that pays K1 − ST if

Elisa Alòs and Raú Merino (UPF) UPF 26 / 47

Elisa Alòs and Raú Merino (UPF) UPF 27 / 47

A forward start option is an European option whose strike is fixed at

max(ST − cST1 , 0),

were c is a constant that we fix in the contract. Several times, c is

Elisa Alòs and Raú Merino (UPF) UPF 29 / 47

Elisa Alòs and Raú Merino (UPF) UPF 30 / 47

Figure – Netflix stocks

Elisa Alòs and Raú Merino (UPF) UPF 31 / 47

A sequence of forward start options is called a cliquet. When one

Elisa Alòs and Raú Merino (UPF) UPF 32 / 47

Compound options are those that have, as an underlying, another

As the price of an option is usually smaller than the price of the

Elisa Alòs and Raú Merino (UPF) UPF 34 / 47

In this type of options, there is a moment before maturity (that we

Elisa Alòs and Raú Merino (UPF) UPF 36 / 47

In lookback options, the payoff depends on the optimal (maximum or

Elisa Alòs and Raú Merino (UPF) UPF 38 / 47

Elisa Alòs and Raú Merino (UPF) UPF 39 / 47

Asian options are European options whose payoff depends on the

Elisa Alòs and Raú Merino (UPF) UPF 41 / 47

Elisa Alòs and Raú Merino (UPF) UPF 42 / 47

Elisa Alòs and Raú Merino (UPF) UPF 43 / 47

For example, exchange options pay max(ST1 − ST2 , 0) at maturity,