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.