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Exotic Derivatives - Outside View by Asad Dossani

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Exotic Derivatives
Sep 2, 2010

This is the final article in the derivatives tutorial. So far, we have looked in detail at futures and options, how they are priced, and how they can be traded. Today, weíll take a look at some of the exotic derivatives that have come up in financial markets today. In general, exotic derivatives are traded over the counter (rather than on an exchange) and usually not by retail investors. Regardless, an astute investor should be aware of what kind of products are out there, even if trading them is impractical. The majority of exotic derivatives take the form of different kinds of options. We will discuss digital, Asian, basket, and barrier options.

A digital or binary option is one that makes a fixed payout if the option finishes in the money, or pays nothing if the option finishes out of the money. For example, if we have a digital call option on gold with a strike of $1200. If the price ends up at or above $1200, the option is in the money, and the owner receives a fixed payout of $100. If the option finishes below $1200, the option holder receives nothing. In this example, there are only two possible outcomes, either $0 or $100. During the life of the option, it will be priced somewhere between $0 and $100 depending on the probability of the option ending up in the money.

An Asian option is one that pays out depending on the average value of the asset over the time period. Assume we have a 3-month call option on gold with a strike of $1200. If over the 3 months the price of gold averaged $1250, the option would have a payout of $50. Asian options tend to be less volatile than standard options especially as the options approach expiry. This is because as the Asian option nears the end of its life, the payout is mostly determined by the previous values of the asset over the optionís life. Contrast this to a standard option, whereby the payout is heavily dependent on where the asset moves towards the end of an optionís life.

A barrier option is one that pays out when a specific level is hit. They can be structured in a variety of ways. For example, we could have a gold option with a barrier of $1200. If over the life of the option, gold crosses $1200, the option is in the money, and the holder receives a payout. They can also be structured so that they start in the money and if a particular level (i.e. barrier) is hit, then the option is worthless.

A basket option is similar to a standard option, except that the payout is based on the values of a combination of assets, rather than a single asset. They can be structured in any way. For example, you could take the weighted average of the oil price and the gold price, and have an option that pays out depending on the weighted average of the two assets. Basket options are also common with currencies. For example, you could have a rupee basket option that would payout based on the value of the Rupee against Dollars, Euros, Pounds, and Yen. The important point to remember about basket options is that their value not only depends on the levels of each asset within the basket, but also the correlations between each asset within the basket. Basket options are more common than we think. An option on the Nifty stock index is a type of basket option. The Nifty stock index is a weighted average of the stock prices within the index, so an option on the index is effectively a basket option. In this case, the basket is all the stocks within the index.

If one had to compile a list of all the exotic derivatives and options out there, it would be many pages long. I have described some of the more common ones, but there are many more, and they can be increasingly complicated. When it comes to exotic derivatives, two parties can structure a trade in any way they want. They can create a contract that pays out depending on certain events, and these can be in any form or fashion. The definition of a derivative is a financial instrument whose value depends on the value of an underlying asset. In theory, we can create any financial contract in any way we want, as long as an underlying asset determines its payouts. Much of quantitative finance is about how to price and value these exotic options, and it is a fascinating field. It may be some time before more exotic options are available to retail investors, but things can change fast. In some exchanges around the world, digital options can now be traded - something new.

I hope this tutorial has been of use and has encouraged individuals to consider (investing using derivatives) as part of their portfolio. Derivatives offer the potential for investors to manage risk, and enhance their overall returns. Its extremely important that one understands how exactly a particular derivative works before trading them. The risks and reward profiles of derivatives are extremely different to traditional stocks or bonds. I encourage those who are interested to do further research to better understand derivatives. Those who can successfully incorporate derivatives into their investments should come out with better risk adjusted returns than otherwise. This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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