Exotic Options

Digital and Chooser Options

Digital options, sometimes called binary options, are of two types:
Asset-or-nothing options pay the holder the asset if the option expires in the money and nothing otherwise. Value of Call = S*N(d1) Value of Put = S*(N-d1) Cash-or-nothing options pay the holder a fixed amount of cash (Say Q) if the option expires in the money and nothing otherwise. As we know that N(d2) is the probability of the asset being above the strike price at the maturity of the option Value of Call = Q*e-rt *N(d2)

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Path-Dependent Options
Path-dependent options are options in which the payoff is determined by the sequence of prices followed by the asset and not just by the price of the asset at expiration. Example: Asian Options, Barrier Options, Look Back Options

Compound Options
Call on Call, Put on Call, Put on Put ,Call on Put, Compound options have two exercise prices and Two exercise dates. For example a call on call. On the first exercise date t1, the holder of the option is entitled to pay the first strike price k1, and receive call option. The call option gives the holder the right to buy the underlying asset for the second strike price, K2, on the second exercise date T2. Compound option will be exercised on the first exercise date only if the value of option on that date is greater than the first strike price.

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Path-Dependent Options (continued)
Asian option: an option in which the final payoff is determined by the average price of the asset during the options life. Some are average price options because the average price substitutes for the asset price at expiration. Others are average strike options because the average price substitutes for the exercise price at expiration. Can be calls or puts. Useful for hedging or speculating when the average is acceptable as a measure of the underlying risk. Also useful for cases where market can be manipulated.

Barrier Options
Barrier Options are options where the payoff depends on whether the underlying assets price reaches a certain level during a certain period of time. Barrier Options: Options that either terminate early if the asset price hits a certain level, called the barrier, or activate only if the asset price hits the barrier.

Kinds of Barrier Options

A knock out (out) option ceases to exist when the underlying asset price reaches a certain barrier. A knock- in (in) option comes into existence only when the underlying asset price reaches the barrier. If the barrier is above the current price, it is called an up-option. If the barrier is below the current price, it is called a down-option. Down -and -out call(H<S): is one type of knock out option. It is a regular call option that ceases to exist if the asset price reaches a certain barrier level, H. The barrier level is below the initial asset price. Up and Out-call (H>S): This is a regular call that ceases to exist if the asset price reaches the barrier level.

 Barrier options are normally cheaper than ordinary options because they provide payoffs for fewer outcomes than ordinary options.

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Path-Dependent Options (continued)
Lookback option: Also called a no-regrets option, it permits purchase of the asset at its lowest price during the options life or sale of the asset at its highest price during the options life.

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Other Exotic Options:
compound and installment options
Option on options. Call on call, call on put etc.,

exchange options
Option to exchange one asset for another.

rainbow options
Options involving two or more risky assets. Ex- basket option where payoff depends on the value of portfolio of assets.

Forward Start Option

Paid for now, with the option becoming effective at a future date

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Bermudan Options
Non standard American option in which early exercise is restricted to certain dates during the life of the option. Exercise price is always the same

As-You-Like-It Option
The owner can decide whether it is a put or a call by a certain date