Exotic Options: Options, Futures, and Other John C. Hull 2008

Exotic Options
Chapter 24
Options, Futures, and Other

Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 1
Types of Exotics
 Package  Binary options
 Nonstandard American  Lookback options
options  Shout options
 Forward start options  Asian options
 Compound options  Options to exchange one
 Chooser options asset for another
 Barrier options  Options involving several
assets
 Volatility and Variance
swaps
John C. Hull 2008 2
Packages (page 555)
 Portfolios of standard options

 Examples from Chapter 10: bull spreads,
bear spreads, straddles, etc
 Often structured to have zero cost
 One popular package is a range forward
contract

John C. Hull 2008 3
Non-Standard American Options
(page 556)
 Exercisable only on specific dates

(Bermudans)
 Early exercise allowed during only
part of life (initial “lock out” period)
 Strike price changes over the life
(warrants, convertibles)

John C. Hull 2008 4
Forward Start Options (page 556)
 Option starts at a future time, T1

 Implicit in employee stock option plans
 Often structured so that strike price equals
asset price at time T1

John C. Hull 2008 5
Compound Option (page 557)
 Option to buy or sell an option
◦ Call on call
◦ Put on call
◦ Call on put
◦ Put on put
 Can be valued analytically
 Price is quite low compared with a regular
option

John C. Hull 2008 6
Chooser Option “As You Like It”
(page 558)
 Option starts at time 0, matures at T2

 At T1 (0 < T1 < T2) buyer chooses whether it
is a put or call
 This is a package!

John C. Hull 2008 7
Chooser Option as a Package
At time T1 the value is max( c, p)

From put - call parity
 r (T2 T1 )  q (T2 T1 )
p ce K  S1e
The value at time T1 is therefore
c  e  q (T2 T1 ) max( 0, Ke( r  q )(T2 T1 )  S1 )
This is a call maturing at time T2 plus
a put maturing at time T1

John C. Hull 2008 8
Barrier Options (page 558)
 Option comes into existence only if stock
price hits barrier before option maturity
◦ ‘In’ options
 Option dies if stock price hits barrier before
option maturity
◦ ‘Out’ options

John C. Hull 2008 9
Barrier Options (continued)
 Stock price must hit barrier from below
◦ ‘Up’ options
 Stock price must hit barrier from above
◦ ‘Down’ options
 Option may be a put or a call
 Eight possible combinations

John C. Hull 2008 10
Parity Relations
c = cui + cuo
c = cdi + cdo
p = pui + puo
p = pdi + pdo

Binary Options (page 561)
 Cash-or-nothing: pays Q if ST > K, otherwise

pays nothing.
◦ Value = e–rT Q N(d2)
 Asset-or-nothing: pays ST if ST > K,
otherwise pays nothing.
◦ Value = S0e-qT N(d1)

Decomposition of a Call Option
Long Asset-or-Nothing option
Short Cash-or-Nothing option where payoff is
K
Value = S0e-qT N(d1) – e–rT KN(d2)

Lookback Options (page 561-63)
 Floating lookback call pays ST – Smin at time T
(Allows buyer to buy stock at lowest observed price
in some interval of time)
 Floating lookback put pays Smax– ST at time T
(Allows buyer to sell stock at highest observed price
in some interval of time)
 Fixed lookback call pays max(Smax−K, 0)
 Fixed lookback put pays max(K −Smin, 0)
 Analytic valuation for all types

Shout Options (page 563-64)
 Buyer can ‘shout’ once during option life
 Final payoff is either
◦ Usual option payoff, max(ST – K, 0), or
◦ Intrinsic value at time of shout, St – K
 Payoff: max(ST – St , 0) + St – K
 Similar to lookback option but cheaper
 How can a binomial tree be used to value a
shout option?

Asian Options (page 564)
 Payoff related to average stock price
 Average Price options pay:
◦ Call: max(Save – K, 0)
◦ Put: max(K – Save , 0)
 Average Strike options pay:
◦ Call: max(ST – Save , 0)
◦ Put: max(Save – ST , 0)

Asian Options
 No exact analytic valuation
 Can be approximately valued by assuming
that the average stock price is lognormally
distributed

Exchange Options (page 566-67)
 Option to exchange one asset for
another
 For example, an option to exchange
one unit of U for one unit of V
 Payoff is max(VT – UT, 0)

Basket Options (page 567)
 A basket option is an option to buy or sell a
portfolio of assets
 This can be valued by calculating the first
two moments of the value of the basket and
then assuming it is lognormal

Volatility and Variance Swaps
 Agreement to exchange the realized volatility
between time 0 and time T for a prespecified fixed
volatility with both being multiplied by a
prespecified principal
 Variance swap is agreement to exchange the
realized variance rate between time 0 and time T
for a prespecified fixed variance rate with both
being multiplied by a prespecified principal
 Daily return is assumed to be zero in calculating
the volatility or variance rate

Variance Swaps (page 568-69)
 The (risk-neutral) expected variance rate
between times 0 and T can be calculated
from the prices of European call and put
options with different strikes and maturity T
 Variance swaps can therefore be valued
analytically if enough options trade
 For a volatility swap it is necessary to use
the approximate relation
 1  var(V )  
E ( )  E V 1  
ˆ ˆ
2 
ˆ
 8  E (V )  
VIX Index (page 570)
 The expected value of the variance of the
S&P 500 over 30 days is calculated from
the CBOE market prices of European put
and call options on the S&P 500
 This is then multiplied by 365/30 and the
VIX index is set equal to the square root of
the result

How Difficult is it to
Hedge Exotic Options?
 In some cases exotic options are easier to
hedge than the corresponding vanilla
options (e.g., Asian options)
 In other cases they are more difficult to
hedge (e.g., barrier options)

Static Options Replication
(Section 24.14, page 570)
 This involves approximately replicating an

exotic option with a portfolio of vanilla
options
 Underlying principle: if we match the value
of an exotic option on some boundary , we
have matched it at all interior points of the
boundary
 Static options replication can be contrasted
with dynamic options replication where we
have to trade continuously to match the
option
Example
 A 9-month up-and-out call option an a non-

dividend paying stock where S0 = 50, K = 50,
the barrier is 60, r = 10%, and  = 30%
 Any boundary can be chosen but the natural
one is
c (S, 0.75) = MAX(S – 50, 0) when S < 60
c (60, t ) = 0 when 0  t  0.75

Example (continued)
We might try to match the following points

on the boundary
c(S , 0.75) = MAX(S – 50, 0) for S < 60
c(60, 0.50) = 0
c(60, 0.25) = 0
c(60, 0.00) = 0

Example continued
(See Table 24.1, page 572)
We can do this as follows:

+1.00 call with maturity 0.75 & strike 50
–2.66 call with maturity 0.75 & strike 60

Example (continued)
 This portfolio is worth 0.73 at time zero

compared with 0.31 for the up-and out option
 As we use more options the value of the
replicating portfolio converges to the value of
the exotic option
 For example, with 18 points matched on the
horizontal boundary the value of the replicating
portfolio reduces to 0.38; with 100 points being
matched it reduces to 0.32

Using Static Options
Replication
 To hedge an exotic option we short the

portfolio that replicates the boundary
conditions
 The portfolio must be unwound when
any part of the boundary is reached


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Exotic Options

Options, Futures, and Other

 Portfolios of standard options

Options, Futures, and Other

 Exercisable only on specific dates

Options, Futures, and Other

 Option starts at a future time, T1

Options, Futures, and Other

Options, Futures, and Other

 Option starts at time 0, matures at T2

Options, Futures, and Other

At time T1 the value is max( c, p)

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

 Cash-or-nothing: pays Q if ST > K, otherwise

Options, Futures, and Other

Value = S0e-qT N(d1) – e–rT KN(d2)

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

 This involves approximately replicating an

 A 9-month up-and-out call option an a non-

Options, Futures, and Other

We might try to match the following points

Options, Futures, and Other

We can do this as follows:

Options, Futures, and Other

 This portfolio is worth 0.73 at time zero

Options, Futures, and Other

 To hedge an exotic option we short the

Options, Futures, and Other

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