Foreign Exchange: A Practical Guide to the FX Markets

CHAPTER 10

Exotic Options and Structured Products

Creations proceeding from our own heat-oppress’d brains.

—Mark Rubinstein

 

While the options proposed by the academics were cute and exemplified some interesting theoretical problems in option valuation, surely they were not to be taken seriously by men and women of practical affairs.

—Mark Rubinstein

 

the economic equivalent of crack cocaine

—George Soros

WHAT IS AN EXOTIC OPTION?

Perhaps the best definition of an “exotic option” that I have heard comes from Robert Jarrow, a professor at Cornell University. Jarrow defines an exotic option as “anything but vanilla.” By this he means any option that has any associated feature that differs from a standard European (and some would extend this to include a standard American) option.

If you were to characterize the two primary reasons why people use options, they would be “to hedge” and “to implement a view on the market.” Why would someone use an exotic option? In short, to either get more tailored financial “insurance” or to position a more precise “view” (or some would substitute “bet”) on the market. Having said that, the majority of salespeople whose clients use these products would say that they use exotic options because they are “cheaper.” This assertion has always troubled a financial engineer that I know, who tends to respond to that statement, “You get what you pay for.” Nevertheless, an exotic option often involves a lower option premium than the otherwise identical vanilla ...