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In finance, 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.

Consider an equity index. A straight call or put, either American or European would be considered non-exotic (vanilla). 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 lookback 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 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.

Even products traded actively in the market can have the characteristics of exotic options, such as convertible bonds, whose valuation can depend on the price and volatility of the underlying equity, the credit rating, the level and volatility of interest rates, and the correlations between these factors.

Examples

Further reading

  • Haug, Espen Gaarder (2007). The Complete Guide to Option Pricing Formulas. New York: McGraw-Hill. ISBN 0-07-147734-9.  
  • Banks, Erik; Paul Siegel (2007). The Options Applications Handbook: Hedging and Speculating Techniques for Professional Investors. New York: Wiley. ISBN 0-07-145315-6.  
  • Kyprianou, Andreas E.; Wim Schoutens, Paul Wilmott (2005). Exotic Option Pricing and Advanced Levy Models. Hoboken, NJ: John Wiley & Sons. ISBN 0-470-01684-1.  
  • Rebonato, Riccardo (1998). Interest-rate Option Models: Understanding, Analysing and Using Models for Exotic Interest-rate Options. New York: McGraw-Hill. ISBN 0-471-97958-9.  

External links

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