In finance

Finance

"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

, an exotic option is a derivative

Derivative (finance)

A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

 which has features making it more complex than commonly traded products (vanilla options). These products are usually traded over-the-counter

Over-the-counter (finance)

Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....

 (OTC), or are embedded in structured note

Structured note

A structured note is a hybrid security that includes several financial products, typically a stock or bond plus a derivative. A simple example would be a five-year bond tied together with an option contract. The addition of the option contract changes the security's risk/return profile to make it...

s.

The term "exotic option" was popularized by Mark Rubinstein

Mark Rubinstein

Mark Edward Rubinstein is a leading financial economist and financial engineer. He is currently Professor of Finance at the Haas School of Business of the University of California, Berkeley, where he is involved in teaching courses in the , an academic program that is focused on equipping...

's 1990 working paper (published 1992, with Eric Reiner) "Exotic Options", with the term based either on exotic wagers in Horse racing

Horse racing

Horse racing is an equestrian sport that has a long history. Archaeological records indicate that horse racing occurred in ancient Babylon, Syria, and Egypt. Both chariot and mounted horse racing were events in the ancient Greek Olympics by 648 BC...

, or due to the use of international terms such as "Asian option", suggesting the "exotic Orient".

Consider an equity index. A straight call

Call option

A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...

 or put

Put option

A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...

, either American

Option style

In finance, the style or family of an option is a general term denoting the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American options. These options - as well as others where the...

 or European

Option style

In finance, the style or family of an option is a general term denoting the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American options. These options - as well as others where the...

 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
  Asian option
  An Asian option is a special type of option contract. For Asian options the payoff is determined by the average underlying price over some pre-set period of time...
  
   depending on some average, a lookback option
  Lookback option
  Lookback options are a type of exotic option with path dependency, among many other kind of options. The payoff depends on the optimal underlying asset's price occurring over the life of the option. The option allows the holder to "look back" over time to determine the payoff...
  
   depending on the maximum or minimum, a barrier option
  Barrier option
  In finance, a barrier option is a financial derivative which either springs into existence upon the occurrence of the event of the price of the underlying asset breaching a barrier or whose existence is extinguished upon the occurrence of the event of the price of the underlying asset breaching a...
  
   which ceases to exist if a certain level is reached or not reached by the underlying, a digital option, peroni options, range options, etc.)
• It could depend on more than one index (as in a basket option
  Basket option
  A basket option is a financial derivative, more specifically an exotic option, whose underlying is a sum or average of different assets. Examples are index options, options on a portfolio, etc....
  
  s, Himalaya options, Peroni 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
  Quanto
  A quanto is a type of derivative in which the underlying is denominated in one currency,but the instrument itself is settled in another currency at some fixed rate...
  
   or composite option.

Even products traded actively in the market can have the characteristics of exotic options, such as convertible bond

Convertible bond

In finance, a convertible note is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features...

s, whose valuation can depend on the price and volatility

Volatility (finance)

In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...

 of the underlying equity

Stock

The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

, the credit rating

Credit rating

A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...

, the level and volatility

Volatility (finance)

In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...

 of interest rate

Interest rate

An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s, and the correlation

Correlation

In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....

s between these factors.

These instruments are often created by "financial engineers".

Examples

• Barrier
  Barrier option
  In finance, a barrier option is a financial derivative which either springs into existence upon the occurrence of the event of the price of the underlying asset breaching a barrier or whose existence is extinguished upon the occurrence of the event of the price of the underlying asset breaching a...
  
  
• CPPI
• Cliquet
  Cliquet
  A cliquet option or ratchet option is an exotic option consisting of a series of consecutive forward start options. The first is active immediately. The second becomes active when the first expires, etc. Each option is struck at-the-money when it becomes active.A cliquet is, therefore, a series of...
  
  
• Compound option
  Compound option
  Compound option or split-fee option is option on an option. The exercise payoff of a compound option involves the value of another option. A compound option then has two expiration dates and two strike prices. Usually, compounded options are used for currency or fixed income markets where...
  
  
• Digital/Binary option
  Binary option
  In finance, a binary option is a type of option where the payoff is either some fixed amount of some asset or nothing at all. The two main types of binary options are the cash-or-nothing binary option and the asset-or-nothing binary option...
  
  
• Lookback
  Lookback option
  Lookback options are a type of exotic option with path dependency, among many other kind of options. The payoff depends on the optimal underlying asset's price occurring over the life of the option. The option allows the holder to "look back" over time to determine the payoff...
  
  
• Peroni Options
• Rainbow option
  Rainbow option
  Rainbow option is a derivative exposed to two or more sources of uncertainty, as opposed to a simple option that is exposed to one source of uncertainty, such as the price of underlying asset. Rainbow options are usually calls or puts on the best or worst of n underlying assets, or options which...
  
  
• Timer call
  Timer Call
  The Timer Call is an Exotic option, that allows buyers to specify the level of volatility used to price the instrument.As with many leading ideas, the principle of the timer call is remarkably simple: instead of a dealer needing to use an implied volatility to use in pricing the option, the...
  
  
• Unit Contingent Options
• Variance swap
  Variance swap
  A variance swap is an over-the-counter financial derivative that allows one to speculate on or hedge risks associated with the magnitude of movement, i.e. volatility, of some underlying product, like an exchange rate, interest rate, or stock index....
  
  
• Bermudan options

External links

• How Binary Options Work at Financial-edu.com
• Online Exotic Option Calculators:Asian, Barrier, Binary, Chooser, ... , sitmo.com
• Global Derivatives Options Database
• Exotic option equations, the Quant Equation Archive at sitmo.com
• Binary Options Trading Guide
• exotic option simulators, exotic option simulators
• Binary Options FAQs at BinaryOptionsWeekly.com