The exotic options have unique characteristics that make them more complex than the ordinary ones. These characteristics , however, provide a number of options on currency hedging and price risk. Here, we are going to consider some of the exotic options and in which way they could be useful.
Binary (double) or digital option is defined by its unique way of payment. Unlike the traditional call-option in which the final premium increases with the price growth of the underlying asset over the target price, this option gives the buyer a sum amount in the total price of the asset under the target price.
Let’s look at the following example – you are supposed to buy a binary call option with premium 5.5 dollars, payment of 10 dollars for share X with target price 50 dollars. If the maturity price is 50.25 dollars, you get 10. Conversely, if X is 49 dollars, you will not get anything. Even the price has doubled, again get 10 dollars. In this example the basic assets are the shares. However, at the same time the, the most of the traded binary options are a result of events not of securities. Things like price index, value of GDP for a definite period, are basic for these options. As such, the early implementation of the options is impossible.
If you are familiar with the options, you know that there is a difference between those of American and European type. The American may be exercised at any time until maturity, while European track only at the date of maturity. Bermuda are somewhere in between.
These options can be exercised at the maturity, as well as on certain dates during their lives. This type of instrument gives the seller more control over the timing of the exercise, and also it offers a lower price to buyers according to U.S. options, without limitations of Europe.
This derivative called Quanto (Quantity-Adjusting Options), allows the buyer to open position in foreign assets, but with the security of a fixed exchange rate against its own currency. Of course this option will require a higher premium, which is above that one of a traditional call option. This is the additional premium for the seller, bearing the currency risk.
Advantages and Drawbacks
When it comes to the option evaluating, it is traditionally used the model of Black-Scholes. It is not so easy to quantify the Exotic options. This could be both advantage and drawback, as the incorrect evaluation could work for or against the investor. Another dilemma is the ability to trade and the risk of liquidity for exotic options. While for some options there are relatively active markets, then for others, they are rarely traded over-the-counter. Even purely bilateral contracts, without liquidity, are possible.
The Exotic Options offer unique opportunities that make them convenient for the active traders, as well as for particular situations. The difficult evaluation of these derivatives can provide an excellent opportunity for arbitrage. There are plenty of Exotic Options and if you learn how to use them properly, you may take profit from any investment opportunity.