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Exotic options

Securities broker-dealers and investment banks have over the years developed many so-called exotic options. Many of them cross the various markets. The following may be mentioned as examples:

As you like it options (AYLIO)

The AYLIO is an option that allows the holder to convert from one type of option to another at a certain pre-specified point prior to expiration. This is usually from a call to a put or vice versa. This option type is also called "call or put option" or "chooser option".

Average rate options (ARO)

The ARO is an option on which settlement is based on the difference between strike price and the average of the share or index on certain given dates. The "average" attribute of the ARO renders this option less volatile and thus cheaper than a conventional "spot price option". The ARO is also called an "Asian Option".

Barrier options (BAO)

There are many types of barrier options. Their payoff is dependent on the price of the underlying asset and on whether the asset reaches a pre-determined barrier at any time in the life of the option. There are, for example, knock-in options and knock-out options. The former is activated when the price of the underlying asset reaches a pre-determined level. The latter option is "killed" if the price of the underlying reaches a pre-determined level.

Compound options (CO)

A CO is an option on an option. The buyer has the right to buy a specific option at a preset date at a preset price.

Lookback options (LO)

A LO is an option where the payout is determined by using the highest intrinsic value of the underlying security or index over its life. For a lookback call the highest price is used, whereas the lowest price is used in a lookback put.

Quantro options (QO)

A QO is a currency option in terms of which the foreign exchange risks in an underlying security have been eliminated.

Package options (PO)

A PO is a portfolio consisting of standard European calls, standard European puts, forward contracts, cash and the underlying asset itself. An example is a range forward contract.

Forward start options (FSO)

FSOs are options that start their life at some stage in the future. They are used in employee incentive schemes.

Binary options (BIO)

BIOs are options with discontinuous payoffs. An example is a cash-or-nothing call. This pays off nothing if the share price ends up below the strike price at some time in the future and pays a fixed amount if it ends up above the strike price.

Shout options (SO)

SOs are European options where the holder can "shout" to the writer at one time during its life. At the end of the life of the option the holder receives either the usual payoff from a European option or the intrinsic value at the time of the shout whichever is greater.

Other options

There are also other options such as options to exchange one asset for another (exchange options), options involving several assets (rainbow options), basket options, etc.

Summary

An option is the right to buy or sell an asset on or during the period up to the option expiry date which is in the future (in exchange for a premium). The writer has an obligation to receive or deliver the asset on or before expiry date. Options are written on most financial market instruments and many commodities. Seen simply an option is worth the intrinsic value and the time value of the option. The most used pricing formula includes a number of variables.

• Spot (current) price of underlying asset (assume share) (SP).

• Exercise (strike) price (EP).

• Time to expiration.

• Risk free rate (i.e. treasury bill rate).

• Dividends expected on the underlying asset during the life of the option.

• Volatility of the underlying asset (share) price.

Bibliography

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Hull, JC, 2000. Options, futures, & other derivatives (4e). London Prentice-Hall International, Inc.

McInish, TH, 2000. Capital markets: A global perspective. Massachusetts, USA: Blackwell Publishers Inc.

Mishkin, FS and Eakins, SG, 2000. Financial markets and institutions (3e). Reading, Massachusetts: Addison-Wesley.

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SAFEX (Financial Derivatives and Agricultural Products Divisions of the JSE Securities Exchange South Africa), 2003. [Online]. Available: safex.co.za. [Accessed October].

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