ab2

Introduction to Exotic Options

FX Derivatives Seminar 27th November 2004 Raphael Drescher

Derivatives

People generally use derivatives for:

Hedging Implementing a View

Standard Derivatives
Forward
Volatility Value Basis

Hedge an exposure with a forward.

Spot

Advantage - no risk (except basis). Disadvantage - lose opportunities

Hedge an exposure with an option.

European Option

Early Exercise

American Option

Advantage - keep opportunities. Disadvantage - premium

ab2

Exotic Options
What are Exotic Options ?

Non-standard options Options with additional features or functionality Path-dependent (most exotic options) Second / Third generation products

What Exotic Options are NOT

Options on exotic currency pairs Cure for bad positions High quality for low cost --> You get what you pay for

ab2

What can be non-standard

The Type of Option

Doesnt have to be a Call nor a Put payoff may be a a fixed amount or Max[0 , f()], or...

The Underlying

may not be a traded underlying, e.g., volatility

The Underlying Price

may be an average price or a maximum price

The Strike Price

may be an average price or a maximum price

Conditional Events

payoff may depend on spot trading within a range, above/ below certain levels

Payout may be in an other currency

ab2

Exotics : Why do we need them ?

Spot Forwards Options Exotics

More cost effective products

Dont pay for hedging you dont need Reduction of premium at risk

Greater scope to express specific views

Provide optical value Embed spot views into hedging strategies

Greater gearing/leverage for speculative strategies But bad product choices can cause problems
ab2

Barrier Options
SECTION 1

Path dependent
Spot Time

ab2

Barrier Options I
The value of a standard option is related to the expected future
value (intrinsic value)

The value of a barrier option is as well related to the expected

future value under either one or both of the following conditions:

The outstrike has never been touched during lifetime of the option The instrike has been touched during lifetime of the option

The payout (intrinsic value) of a barrier option is exactly the same

as the one of a standard option, again under the condition that the outstrike is never reached or the instrike is touched.

ab2

Barrier Options II
Prices of barrier options are also influenced - besides outstrikes or
instrikes - by spot, strike price, interest rates, time till expiration and implied volatility, although in a complete different manner than for standard options different than those of standard options

Risk parameters (Delta, Gamma, Tau, etc.) might be significantly This fact has implication in terms of risk management for both,
the client and the bank

and makes those options look attractive

better hedging variations with exotic options possibility of expressing a market view through different strategies tailor made zero upfront premium strategies leverage of exotic options are very big more delta for less premium

ab2

Barrier options terminology

Options with OUT- strikes:

The option starts active Down-and-out: Barrier lies below the spot The option deactivates if the spot price drops below the barrier Up-and-out: Barrier lies above the spot The option becomes inactive if the spot rises above the barrier

Options with IN- strikes

The option starts inactive Down-and-in: Barrier lies below the spot The option only activates if the spot price falls below the barrier Up-and-in: Barrier lies above the spot The option activates only if the spot rises above the barrier

ab2

100 Vanilla Call

Spot at expiry above 100 = Option has a value Spot at expiry below 100 = Option has Zero Value
117.50 112.50 107.50 S=K=100 102.50 97.50 92.50 87.50

ab2

82.50
9

100 Vanilla Call

Spot can take different paths to end at the same level Payout does not depend on what path spot followed Payout 7.50
117.50 112.50 107.50 102.50 S=K=100 97.50 92.50 87.50

ab2

82.50
10

100 Call with Knock Out at 97.50

Extra condition for payout to occur applies Smaller probability of payout Payout is path dependant = Premium discount
117.50 112.50 107.50 S=K=100 Outstrike = 97.50 102.50 97.50 92.50 87.50

ab2

82.50
11

Knock-Out Options: Vanilla versus Knock-Out

Spot

Spot

Strike

Strike

Standard Call Option

Standard Put Option

Spot

Spot

OX

Strike

Strike

OX

Knock Out Call Option

Knock Out Put Option

ab2

Barrier is placed in the OTM direction

Knock-Out Options: EURUSD (Hedger Example)

Customer needs to buy EUR and wants to protect himself from a adverse market move, e.g. a higher EUR against Assumption: USD; spot CHF 1.3000 per 1 USD

Strategy:

Buy a 1.3200 USD Call / CHF Put, Outstrike 1.2750, expiration 3 months, amount USD 10m. Premium 135 CHF pips (0.0135 USD per 1 EUR) Knock Out option is 23% cheaper than a Plain Vanilla option (1.3200 EUR Call, 3mths, costs 175 USD pips) If the EURUSD rate touches once 1.2750 over the next 3 months, the option expires immediately If the Outstrike of 1.2750 is not reached, the Knock Out option behaves like a Standard option at expiration

Analysis:

ab2

Knocked-Out... Is this good or bad?

If the OX is touched, the option and thus the protection ceases to exist. The hedge is no longer in place But we get a chance to rehedge on a better level

either through a new Call (with OX) or by linking a Spot Buy Order to the OX initially

Summary: The Knock Out Call gives opportunities to rehedge at more favourable levels, but monitoring and action is needed Reasons for using a Knock Out Option

Lower premium Greater benefit from a move in spot (higher delta) Option only exists when needed

Alternative names used:

Up-and-Out Down-and-Out

ab2

14

Kick-Out Options: Vanilla versus Kick-Out

Spot

Spot

Strike

Strike

Standard Call Option

Standard Put Option

Spot

Spot

Strike

OX

OX

Strike

Kick Out Call Option

Kick Out Put Option

ab2

Barrier is placed in the ITM direction

Kick-Out Option: EURUSD (Investor Example)

Customer anticipates a higher EUR against the USD towards 1.4000 but not above and wants to profit from this Assumption: movement; Spot USD 1.3000 per 1 EUR

Strategy:

Buy a 1.3200 EUR Call/USD Put, Kick-Out 1.4000, expiration 3 month, amount EUR 10m. Premium 70 USD pips (0.0070 USD per 1 EUR) Kick Out option is 60% cheaper than the plain vanilla option (1.3200 EUR Call, 3mths, costs 175 USD pips) If the EUR/USD rate rises at or above 1.4000 over the next 3 months, the option expires immediately. If the outstrike of 1.4000 is never touched, the Kick Out option behaves like a standard option at expiration

Analysis:

ab2

Long Kick-Out Option: EUR/USD (Investor Example)

Value at expiration 0.0800 0.0600 0.0400

Exotic Option: Kick Out Call Strike Vanilla Outstrike

Spot EURUSD
1.3200 1.3300 1.3400 1.3500 1.3600 1.3700 1.3800 1.4000

0.0200 0.0000 -0.0200 -0.0400

ab2

17

Kick Out Option

Reasons for using a Kick Out Option

Very low Premium in exchange for potential give up Expresses mildly bullish/bearish view Benefit from high Volatility levels (Long Kick Out = Short Volatility) Benefit from stable spot market (Long Kick Out = Earn Decay)

Alternative names used:

Reverse Knock-Out Option

ab2

18

Kick-In Options: Vanilla versus Kick-In

Spot

Spot

Strike

Strike

Standard Call Option

Standard Put Option

Spot

Spot

Strike

IX

Strike

Kick In Call Option

Kick In Put Option

ab2

Kick-In Option: EURUSD

Customer anticipates a somewhat higher EUR against the USD in the next couple of weeks in a volatile Assumption: environment. Spot USD 1.3000 per 1 EUR

Sell a 1.3000 EUR Put/USD Call, Kick-In 1.2600,

Strategy: expiration 3 month, amount EUR 10m.

Premium receive 230 USD pips (0.0230 USD per 1 EUR) Kick In option is 8% less rich in premium than the
plain vanilla option (1.3000 EUR Put, 2mth, receive 250 USD pips) Analysis:

If the EURUSD rate falls at or below 1.2600 over the

next 3 months, the option becomes alive and behaves like a standard option at expiration. If the instrike of 1.2600 is never touched, the Kick In option does not exist at the expiry date.

ab2

Kick In Option
Reasons for using a Kick In Option

Option buyer Lower premium Hedge appears only when needed Fits view of a sharp move in spot Option seller Alternative to selling Standard Option Collect premium with no obligation if Instrike is not breached Often used in Risk Reversal Strategies

Alternative names used:

Reverse Knock-In Option

ab2

21

Payout Options
SECTION 2

Options that pay out an amount depending on certain parameters

ab2

One Touch Option

What is a One Touch?

Pays a fixed amount if Trigger is touched during life of option Quoted as % of Payout (Pay 20% - receive 100% if touched)

Reasons for using a One Touch Option

One Touch buyer: Strong directional view Fixed Risk-Reward One Touch seller: Alternative to short Standard Option in Risk Reversal Limited downside

Alternative names used:

Binary Option Lock-In Option American Digital Option

ab2

23

One Touch Example

Market Data EURUSD Spot: 1.3000 Product Data Expiry: 3 month Payout: 100,000 EUR Trigger: 1.3700 Premium: 30% of payout

Right to receive fixed payout of 100,000 EUR Pays out if spot reaches 1.3700 before expiration The up front premium is 30% of payout (30,000 EUR)

ab2

24

One Touch

90%

60% % EUR Payout

30%

0% 1.26 -30%

1.28

1.30

1.32

1.34

1.36

1.38

Spot at Expiration

ab2

25

No Touch Option Double Lock Out

What is a No Touch Option?

Pays a fixed amount if Trigger is NOT touched during life of option Quoted as % of Payout (Pay 20% - receive 100% if not touched)

One Touch and No Touch prices are connected

Probability of NOT touching + Probability of touching = 100% Price of One Touch + Price of No Touch = 100%

P/L of buying a One Touch Option is the same as selling the No

Touch Option with the same trigger

Pay outs can be @ touch or @ maturity

ab2

26

Double No Touch Option

What is a Double No Touch ?

The Double No Touch Option pays a pre-specified payout amount if and only if Spot does not touch either of the two Outstrikes during the life of the option

Reasons for using a Double No Touch Option

Benefit from range bound spot market Short Volatility with limited downside (premium) Fixed Risk-Reward Earn time decay as time moves on

Alternative names used:

Double Lock-Out Option Range Bet Range Binary

ab2

27

Double No Touch Option Example

Market Data USD/JPY Spot: 103.00 Product Data Expiry 3 month Payout 100,000 USD Outstrikes 99.0 & 106.0 Premium 20% of payout

Right to receive fixed payout of 100,000 USD. Pays out if spot does not reach 99.0 or 106.0 before expiration. Up front premium is 20% (20,000 USD) Option will decay in your favour (from 20,000 to 100,000).

ab2

28

Double No Touch

100% 80% 60% % USD Payout 40% 20% 0% 95 -20% -40% Spot at Expiration 97 99 101 103 105 107 109 111

ab2

29

Digital options
Fixed payout made at expiry if spot finishes ITM with respect to
strike

Also known as

Rule of thumb: Digital price = of One Touch price 3m EURUSD 1.3700 Digital Call costs 17% You pay EUR 17,000 today and get EUR 100,000 at expiry if EURUSD trades at or above 1.3700 at expiry.

Binary Options All-or-Nothing Options Cash-or-Nothing Asset-or-Nothing Options

Digital Call:
Pay-out at expiry

X
Pay-out at expiry

Spot at expiry

Digital Put
ab2

Spot at expiry

Multiple Assets and other Exotics

SECTION 3

Multiple Assets
A Ccy 1 Ccy 3 B D C Ccy 2

ab2

Multiple assets

The value of single asset options only depends on the price of one underlying currency pair The value of a multiple asset option depends on more than one currency pair

Multiple Assets
A Ccy 1 Ccy 3 B D C Ccy 2

Basket Options Quanto Options

ab2

32

Basket Options
Managing a Portfolio of Currencies

A basket option gives the holder the right to exchange one

currency for a portfolio of currencies

A basket option can be designed so that the holder has the right
to buy all the basket currencies, sell all the basket currencies, or have mixed cash flows against the base currency vanilla options

Basket options are less expensive than the sum of the individual
The Impact of Correlation on the Basket Price

The basket option discount to the

2.50%

Basket Price [% U SD ]

vanillas is driven by the correlation between the basket of currencies and the base currency

Sum of premiums of vanilla options

2.00% 1.50% 1.00% 0.50% 0.00% -1 -0.5 0 0.5 1

Premium of basket option

ab2

Correlation
33

Basket Options - Example

Managing a Portfolio of Currencies

A EUR based Asset Manager wants to hedge the following global portfolio on 1yr time horizon:
EUR USD GBP JPY local ccy 50 50 20 2,500 FX 1.2200 0.6830 134.85 in EUR 50 41.0 29.3 18.5 138.8 in % 36% 30% 21% 13%
13% 36% 21%

EUR USD 30% GBP JPY

The ATMS EUR Basket Value is 138.8m

Buy a Basket Put/ EUR Call, strike 138.8 for EUR 2.1m (1.5%) If at expiry the Fixed Currency amounts yield less than EUR 138.8m you will exercise the option to sell the Basket Fixed Currency Amounts for EUR 138.8m Sum of the vanilla options costs EUR 3.4m (2.4%)
PnL

Basket Value EUR 125m EUR 138.8m EUR 150m

34

ab2

Quanto Options
Hedges an exposure into a 3rd currency

A Quanto option is an option where any payout at expiry is

converted to a third currency at an FX rate fixed on trade date. obligated to receive any payout in the quanto currency.

Buyer has the right to exercise the option (just like a vanilla) but is Example:

Client looking to take a position in EURJPY does not wish to have currency exposure on the option payout With a vanilla option, if the EURJPY option is in-the-money at expiry, the client would receive JPY payout Would convert into USD at the prevailing USDJPY exchange rate Payout could have been eroded by a weakening JPY vs. the USD

To eliminate this USDJPY risk, the client could purchase a EURJPY

option quantoed into USD, where the JPY payout is converted into USD at a USDJPY rate chosen at the time of trading

ab2

35

Quanto Options - Example

Situation: A USD-based client wanting to play a bullish EURJPY view

6-month 135.00 strike EUR Call / JPY Put The JPY payout can be converted into USD at a Quanto Strike of 100.00 JPY per USD $1.30m
$1.20m Quanto Non-Quanto

Price: Vanilla 135.00 EUR Call: 2.00% Quanto 135.00 EUR Call with 100 quanto strike: 2.30%

$1.10m $1.0m $.90m $.80m $.70m 85

USD Payout at Expiry

90 95 100 105 110 115 120 125 130

Payout: At expiry, EURJPY spot is at 145.00 and USDJPY spot is at 120.00 JPY Payout of EUR Call: JPY10 per EUR on 10m, or JPY 100m, converted to USD at the quanto strike of 100 gives a USD payout of $1m If the USD-based client had used a vanilla option, their JPY option payout converted to USD at 120 would only have been $833k a 16% reduction ab2 Result: Client protected the USD value of option payout
36

Benefits of the quanto option

The attractive feature of a quanto option is that the JPY payout
can be converted to USD at 100, regardless of

USDJPY exchange rate at expiry JPY payout amount at expiry

If EURJPY were 140 at expiry, and the JPY payout had been JPY
200m, that amount could still be converted to USD at the quanto strike of 100

A quanto option can be thought of as a quantity adjusting

option, providing currency protection on a notional not known until expiry

Hedge an unknown notional the option payout in your non-home currency!

ab2

37

Vanilla or Exotic Options The choice is yours!

Whats your scope in the Foreign Exchange Market?

e.g. are your a Hedger, an Investor or a Yield Enhancer?

What are your expectations?

Spot-Market moves up/down/sideways? Volatility moves up/down/sideways? Timing? (Windows)

Whats your risk appetite?

Long versus short position or a combination thereof? Desired leverage factor

ab2

38

Disclaimer
This report has been prepared by UBS AG or an affiliate thereof (UBS). In certain countries UBS AG is referred to as UBS SA. This report is for distribution only under such circumstances as may be permitted by applicable law. It has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, except with respect to information concerning UBS AG, its subsidiaries and affiliates, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the report. The report should not be regarded by recipients as a substitute for the exercise of their own judgement. Any opinions expressed in this report are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or groups of UBS as a result of using different assumptions and criteria. UBS is under no obligation to update or keep current the information contained herein. UBS, its directors, officers and employees (excluding the US broker-dealer unless specifically disclosed under required disclosures) or clients may have or have had interests or long or short positions in the securities or other financial instruments referred to herein, and may at any time make purchases and/or sales in them as principal or agent. UBS (excluding the US broker-dealer unless specifically disclosed under Required Disclosures) may act or have acted as market-maker in the securities or other financial instruments discussed in this report. Furthermore, UBS may have or have had a relationship with or may provide or has provided investment banking, capital markets and/or other financial services to the relevant companies. Employees of UBS may serve or have served as officers or directors of the relevant companies. UBS may rely on information barriers, such as Chinese Walls, to control the flow of information contained in one or more areas within UBS, into other areas, units, groups or affiliates of UBS. The securities described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. Options, derivative products and futures are not suitable for all investors, and trading in these instruments is considered risky. Past performance is not necessarily indicative of future results. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this report. For investment advice, trade execution or other enquiries, clients should contact their local sales representative. Neither UBS nor any of its affiliates, nor any of UBS' or any of its affiliates, directors, employees or agents accepts any liability for any loss or damage arising out of the use of all or any part of this report. Additional information will be made available upon request. United Kingdom and rest of Europe: Except as otherwise specified herein, this material is communicated by UBS Limited, a subsidiary of UBS AG, to persons who are market counterparties or intermediate customers (as detailed in the FSA Rules) and is only available to such persons. The information contained herein does not apply to, and should not be relied upon by, private customers. Switzerland: Distributed by UBS AG to persons who are institutional investors only. Italy: Should persons receiving this research in Italy require additional information or wish to effect transactions in the relevant securities, they should contact Giubergia UBS SIM SpA, an associate of UBS SA, in Milan. South Africa: UBS Securities South Africa (Pty) Limited (incorporating J.D. Anderson & Co.) is a member of the JSE Securities Exchange SA. United States: Distributed to US persons by either UBS Securities LLC or by UBS Financial Services Inc., subsidiaries of UBS AG; or by a group, subsidiary or affiliate of UBS AG that is not registered as a US broker-dealer (a non-US affiliate), to major US institutional investors only. UBS Securities LLC or UBS Financial Services Inc. accepts responsibility for the content of a report prepared by another non-US affiliate when distributed to US persons by UBS Securities LLC or UBS Financial Services Inc. All transactions by a US person in the securities mentioned in this report must be effected through UBS Securities LLC or UBS Financial Services Inc., and not through a non-US affiliate. Canada: Distributed by UBS Securities Canada Inc., a subsidiary of UBS AG and a member of the principal Canadian stock exchanges & CIPF. A statement of its financial condition and a list of its directors and senior officers will be provided upon request. Hong Kong: Distributed by UBS Securities Asia Limited. Singapore: Distributed by UBS Securities Singapore Pte. Ltd. Japan: Distributed by UBS Securities Japan Ltd to institutional investors only. Australia: Distributed by UBS Capital Markets Australia Ltd and UBS Securities Australia Ltd licensed securities dealers. New Zealand: Distributed by UBS New Zealand Ltd 2004 UBS. All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect.

ab2

39