Exotic Options and Other Nonstandard Products

Chapter 20

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.1

Types of Exotic Options

Packages Nonstandard

American options Forward start options Compound options Chooser options Barrier options Binary options
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.2

Types of Exotic Options continued

Lookback

options Shout options Asian options Options to exchange one asset for another Options involving several assets

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.3

Packages (page 444)

Portfolios

of standard options Examples from Chapter 10: bull spreads, bear spreads, straddles, etc Example from Chapter 13: Range forward contracts Packages are often structured to have zero cost
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.4

Nonstandard American Options

(page 444)

Exercisable

only on specific dates (Bermudans) Early exercise allowed during only part of life (e.g. there may be an initial lock out period) Strike price changes over the life

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.5

Forward Start Options (page 444)

Option

starts at a future time, T Most common in employee stock option plans Often structured so that strike price equals asset price at time T

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.6

Compound Option (page 444)

Option

to buy or sell an option

Call on call Put on call Call on put Put on put

Very

sensitive to volatility

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.7

Chooser Option As You Like It

(page 445)

Option At

starts at time 0, matures at T2

T1 (0 < T1 < T2) buyer chooses whether it is a put or call A few lines of algebra shows that this is a package

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.8

Chooser Option as a Package

At time T1 the value is max( c, p ) From put - call parity p = c + e r (T2 T1 ) K S1e q (T2 T1 ) 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
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.9

Barrier Options (page 445)

In

options: come into existence only if asset price hits barrier before option maturity Out options: are knocked out if asset price hits barrier before option maturity

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.10

Barrier Options (continued)

Up

options: asset price must hit barrier from below Down options: asset price must hit barrier from above Option may be a put or a call Eight possible combinations

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.11

Parity Relations

c = cui + cuo c = cdi + cdo p = pui + puo p = pdi + pdo

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.12

Binary Options
Cash-or-nothing:

(page 446)

pays Q if S > K at time T, otherwise pays 0. Value = erT Q N(d2) pays S if S > K at time T, otherwise pays 0. Value = S0 N(d1)

Asset-or-nothing:

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.13

Decomposition of a Call Option

Long Asset-or-Nothing option Short Cash-or-Nothing option where payoff is K Value = S0 N(d1) erT KN(d2)

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.14

Lookback Options (page 446)

Lookback Allows

call pays ST Smin at time T

buyer to buy stock at lowest observed price in some interval of time Lookback put pays S S at time T max T
Allows

buyer to sell stock at highest observed price in some interval of time

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.15

Shout Options (page 447)

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, S K

Payoff:

max(ST S , 0) + S K Similar to lookback option but cheaper How can a binomial tree be used to value a shout option?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.16

Asian Options (page 447)

Payoff

related to average stock price Average Price options pay:

max(Save K, 0) (call), or max(K Save , 0) (put)

Average

Strike options pay:

max(ST Save , 0) (call), or max(Save ST , 0) (put)

20.17

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

Options to Exchange (page 448)

Option

to exchange one asset for another When asset with price U can be exchanged for asset with price V payoff is max(VT UT, 0)
min(U
T

, VT) =VT max(VT UT, 0) , VT) =UT + max(VT UT, 0)

20.18

max(U

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

Types of Mortgage-Backed Securities (MBSs)

Pass-Through Collateralized

Mortgage Obligation (CMO) Interest Only (IO) Principal Only (PO)

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.19

Variations on Vanilla Interest Rate Swaps (page 450)

Principal

different on two sides Payment frequency different on two sides Can be floating for floating instead of floating for fixed

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.20

Compounding Swaps (page 450)

Interest is compounded instead of being paid In Business Snapshot 20.2 the fixed side is 6% compounded forward at 6.3% while the floating side is LIBOR plus 20 bps compounded forward at LIBOR plus 10 bps.

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.21

Currency Swaps (page 451)

Fixed

for fixed Fixed for floating Floating for floating

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.22

More Complex Swaps

LIBOR-in-arrears swaps CMS and CMT swaps Differential swaps

These swaps cannot be correctly valued by assuming that forward rates will be realized. We must assume that the realized rate is the forward rate plus a convexity adjustment
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.23

Equity Swaps
Total

return on an equity index is exchanged periodically for a fixed or floating return See Business Snapshot 20.3 on page 454

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.24

Swaps with Embedded Options

Accrual

swaps Cancelable swaps Cancelable compounding swaps

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.25

Other Swaps
Indexed

principal swap Commodity swap Volatility swap Bizzarre deals: for example the P&G 5/30 swap ( See Business Snapshot 20.4 on page 456)

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

20.26