Exotic option

In financial markets, options are a class of derivative allowing the optional purchase or sale of an underlying instrument.

Options typically will fall into one of two distinct categories of complexity - vanilla option or exotic.

These two classes are differentiated by the intricacies associated with valuation; that is, how a fair market price for such a derivative instrument is determined. The so-called plain vanilla option is by far the simpler of the two.

Exotic options are derivative instruments that are customised to suit a specific customers requirements. They trade in what is called the over the counter or OTC market.

Contrast this to vanilla options, which are highly uniform and standardised instruments; these products, which may or may not precisely suit a unique customers requirements, trade on exchanges.

It is useful to consider vanilla options mass produced products, created, marketed and sold in large volumes.

Exotic options, by comparision, are painstakingly hand crafted for a specific customer; no two customers exotic options will be precisely identical, since every customer will have slightly different requirements.

To understand these instruments, consider the following example :

If someone wished to acquire, for example, 1,000 shares of IBM stock, but was uncertain if IBM would increase in value, the purchase of a simple call option would suffice. This instrument would allow it's holder to acquire IBM - the underlying - for a predetermined price regardless of the current market value of IBM shares.

Clearly, if the value of IBM shares appreciate, this stock option could be quite valuable.

This is a plain vanilla option, since lots of people - customers - may wish to purchase IBM; an option such as this one can be mass produced and sold to many different customers.

On the other hand, consider the situation of a programmer for a company who believes that if the German economy improves, and if the US Dollar depreciates against the Deutsche Mark and if US Interest Rates fall then IBM stock will appreciate.

This individual may wish to acquire an options contract allowing her to acquire IBM shares under these highly unique constraints. An option of this variety is called an exotic option.

Clearly, the market for such highly customised instruments is quite small.

Exotic options are sometimes referred to as toxic waste by Investment Bankers. This is due to the subtle problems that may develop while attempting to value such highly complex instruments.