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Exotic Options Trading

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Written by an experienced trader and consultant, Frans de Weert’s Exotic Options Trading offers a risk-focused approach to the pricing of exotic options. By giving readers the necessary tools to understand exotic options, this book serves as a manual to equip the reader with the skills to price and risk manage the most common and the most complex exotic options.

De Weert begins by explaining the risks associated with trading an exotic option before dissecting these risks through a detailed analysis of the actual economics and Greeks rather than solely stating the mathematical formulae. The book limits the use of mathematics to explain exotic options from an economic and risk perspective by means of real life examples leading to a practical interpretation of the mathematical pricing formulae.

The book covers conventional options, digital options, barrier options, cliquets, quanto options, outperformance options and variance swaps, and explains difficult concepts in simple terms, with a practical approach that gives the reader a full understanding of every aspect of each exotic option. The book also discusses structured notes with exotic options embedded in them, such as reverse convertibles, callable and puttable reverse convertibles and autocallables and shows the rationale behind these structures and their associated risks.

For each exotic option, the author makes clear why there is an investor demand; explains where the risks lie and how this affects the actual pricing; shows how best to hedge any vega or gamma exposure embedded in the exotic option and discusses the skew exposure.

By explaining the practical implications for every exotic option and how it affects the price, in addition to the necessary mathematical derivations and tools for pricing exotic options, Exotic Options Trading removes the mystique surrounding exotic options in order to give the reader a full understanding of every aspect of each exotic option, creating a useable tool for dealing with exotic options in practice.

“ Although exotic options are not a new subject in finance, the coverage traditionally afforded by many texts is either too high level or overly mathematical. De Weert's exceptional text fills this gap superbly. It is a rigorous treatment of a number of exotic structures and includes numerous examples to clearly illustrate the principles. What makes this book unique is that it manages to strike a fantastic balance between the theory and actual trading practice. Although it may be something of an overused phrase to describe this book as compulsory reading, I can assure any reader they will not be disappointed. ”

—Neil Schofield, Training Consultant and author of Commodity Derivatives: Markets and Applications

“Exotic Options Trading does an excellent job in providing a succinct and exhaustive overview of exotic options. The real edge of this book is that it explains exotic options from a risk and economical perspective and provides a clear link to the actual profit and pricing formulae. In short, a must read for anyone who wants to get deep insights into exotic options and start trading them profitably. ”

—Arturo Bignardi

Author(s): Frans de Weert
Series: The Wiley Finance Series
Publisher: Wiley
Year: 2008

Language: English
Pages: 205

Exotic Options Trading......Page 4
Contents......Page 8
Preface......Page 14
Acknowledgements......Page 16
1 Introduction......Page 18
2.1 Call and Put Options and Forwards......Page 20
2.2 Pricing Calls and Puts......Page 23
2.4 Determining the Strike of the Forward......Page 25
2.5 Pricing of Stock Options Including Dividends......Page 26
2.6 Pricing Options in Terms of the Forward......Page 27
2.7 Put-Call Parity......Page 28
2.8 Delta......Page 29
2.10 Gamma......Page 31
2.11 Vega......Page 33
2.12 Theta......Page 35
2.13 Higher Order Derivatives Like Vanna and Vomma......Page 36
2.14 Options’ Interest Rate Exposure in Terms of Financing the Delta Hedge......Page 38
3 Profit on Gamma and Relation to Theta......Page 40
4 Delta Cash and Gamma Cash......Page 42
4.1 Example: Delta and Gamma Cash......Page 43
5.1 Reasons for Higher Realised Volatility in Falling Markets......Page 44
5.2 Skew Through Time: ‘The Term Structure of Skew’......Page 45
5.3 Skew and its Effect on Delta......Page 46
5.4 Skew in FX versus Skew in Equity: ‘Smile versus Downward Sloping’......Page 49
5.5 Pricing Options Using the Skew Curve......Page 51
6.1 Call Spread......Page 52
6.2 Put Spread......Page 54
6.3 Collar......Page 56
6.4 Straddle......Page 57
6.5 Strangle......Page 59
7.1 Monte Carlo Process Principle......Page 62
7.3 Binomial Tree Example......Page 63
7.4 The Workings of the Monte Carlo Process......Page 65
8.1 Pricing Example: Simple Chooser Option......Page 66
8.2 Rationale Behind Chooser Option Strategies......Page 68
9 Digital Options......Page 70
9.3 Width of the Call Spread versus Gearing......Page 72
10 Barrier Options......Page 74
10.2 Delta Change over the Barrier for a Down-and-In Put Option......Page 75
10.3 Factors Influencing the Magnitude of the Barrier Shift......Page 77
10.6 Up-and-Out Call......Page 80
10.8 Vega Exposure Up-and-Out Call Option......Page 81
10.11 Barrier at Maturity Only......Page 82
10.12 Skew and Barrier Options......Page 83
10.13 Double Barriers......Page 85
11.1 Forward Starting and Regular Options Compared......Page 88
11.2 Hedging the Skew Delta of the Forward Start Option......Page 89
11.3 The Forward Start Option and the Skew Term Structure......Page 90
11.4 Analytically Short Skew but Dynamically No Skew Exposure......Page 91
11.5 Forward Starting Greeks......Page 92
12.1 Example: Ladder Option......Page 94
12.2 Pricing the Ladder Option......Page 95
13.1 Pricing and Gamma Profile of Fixed Strike Lookback Options......Page 96
13.2 Pricing and Risk of a Floating Strike Lookback Option......Page 97
14.1 The Ratchet Option......Page 100
14.2 Risks of a Ratchet Option......Page 102
15.1 Example: Knock-in Reverse Convertible......Page 104
15.3 Market Conditions for Most Attractive Coupon......Page 106
15.4 Hedging the Reverse Convertible......Page 107
16.1 Example: Autocallable Reverse Convertible......Page 110
16.2 Pricing the Autocallable......Page 112
16.3 Autocallable Pricing without Conditional Coupon......Page 114
16.4 Interest/Equity Correlation within the Autocallable......Page 115
17.1 Pricing the Callable Reverse Convertible......Page 116
17.2 Pricing the Puttable Reverse Convertible......Page 119
18.1 Pricing the Geometric Asian Out Option......Page 122
18.2 Pricing the Arithmetic Asian Out Option......Page 124
18.3 Delta Hedging the Arithmetic Asian Out Option......Page 126
18.5 Delta Hedging the Asian in Option......Page 127
18.6 Asian in Forward......Page 129
18.7 Pricing the Asian in Forward......Page 131
18.8 Asian in Forward with Optional Early Termination......Page 133
19.1 Pricing and Correlation Risk of the Option......Page 136
19.2 Hedging FX Exposure on the Quanto Option......Page 139
20.1 An Example of the Composite Option......Page 142
20.2 Hedging FX Exposure on the Composite Option......Page 143
21.1 Example of an Outperformance Option......Page 146
21.2 Outperformance Option Described as a Composite Option......Page 147
21.3 Correlation Position of the Outperformance Option......Page 148
21.4 Hedging of Outperformance Options......Page 149
22.1 Correlation Risk for the Best of Option......Page 152
22.2 Correlation Risk for the Worst of Option......Page 154
22.3 Hybrids......Page 155
23 Variance Swaps......Page 156
23.2 Replicating the Variance Swap with Options......Page 157
23.3 Greeks of the Variance Swap......Page 159
23.4 Mystery of Gamma Without Delta......Page 161
23.5 Realised Variance Volatility versus Standard Deviation......Page 162
23.6 Event Risk of a Variance Swap versus a Single Option......Page 163
23.8 Skew Delta......Page 164
23.9 Vega Convexity......Page 165
24.1 Pricing Basket Options......Page 168
24.2 Basket Volatility Derived From its Constituents......Page 169
24.5 Dispersion Means Trading a Combination of Volatility and Correlation......Page 170
24.6 Ratio’d Vega Dispersion......Page 172
24.7 Skew Delta Position Embedded in Dispersion......Page 173
25.1 Capital Guaranteed Products......Page 174
25.2 Attractive Market Conditions for Capital Guaranteed Products......Page 175
25.3 Exposure Products for the Cautious Equity Investor......Page 177
25.4 Leveraged Products for the Risk Seeking Investor......Page 180
Appendix A Variance of a Composite Option and Outperformance Option......Page 184
Appendix B Replicating the Variance Swap......Page 186
Bibliography......Page 192
Index......Page 194