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#FRM Tutorial: What are Exotic Options / Vanilla Options ?

February 15, 2010
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An exotic option is a derivative which has features making it more complex than commonly traded products (vanilla options). These products are usually traded over-the-counter (OTC), or are embedded in structured notes.

An exotic product could have one or more of the following features:

  • The payoff at maturity depends not just on the value of the underlying index at maturity, but at its value at several times during the contract's life.
  • It could be an Asian option depending on some average, a look-back option depending on the maximum or minimum, a barrier option which ceases to exist if a certain level is reached or not reached by the underlying, a digital option, range options, etc.
  • It could depend on more than one index; as in case of a basket options, Himalaya options, or other mountain range options, outperformance options, etc.
  • There could be callability and putability rights.
  • It could involve foreign exchange rates in various ways, such as a quanto or composite option.


#FRM Exotic And Vanilla Options

Similarly there are few more important types for classification:

  • Barrier Options - They let the investor gain from their expectation of share price path movement, for example, the share will first go down and then rocket up. There are several types of barriers:
  • Binary options: They are options with discontinuous payoffs. Another type of binary option is an asset or nothing call. This payoff is nothing if the underlying asset price ends up below the strike price and pays the asset if it ends up above the strike price.
  • Asian Options: They are a type of averaging option. Most common is to average the share price. The payout is determined by deducting the average from the strike. This option is far cheaper because the volatility of an average is lower than that of the price itself.
  • Compound Option: It is an option on an option. Here, the holder has a Call option that expires - 10th March to purchase a Call option for £2.00 which will then give the holder the right to purchase the shares at £12.00 on 31st October. The holder pays less up-front, thus effectively making this a highly geared instrument.
  • Chooser option: A chooser option has a unique feature. After a specified period of time, the holder can choose whether the option is a call or a put. More complex chooser options can be defined where the call and the put do not have the same strike price and the time to maturity

To guarantee your success at passing the FRM exam at one go, follow the link to FRM Concept Checkers for many more concepts!


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