Introduction to Derivatives

Lecture 8

Exotic Options

Till now we dealt with plain vanilla options having standard properties. Financial engineers have created many Exotic Options. These have been created:

To meet a genuine hedging need. They provide some tax, accounting, legal or regulatory benefit to treasurer. To reflect treasurers view of potential market movements. To lure an unwary treasurer.

Types of Exotic Options

Forward start options Compound options Chooser options Barrier options Binary options Lookback options Shout options Asian options Options to exchange one asset for another.

Asian Options

Payoff is related to average stock price during some part of life of option. Average Price options pay:

max(Save K, 0) (call), or max(K Save , 0) (put) max(ST Save , 0) (call), or max(Save ST , 0) (put)

Average Strike options pay:

Hawaiian Options

They are combinations of Asian & American Options. They are essentially Asian options that allow early exercise.

Barrier Options

Barrier Options: payoff depends on whether underlying assets price reached a certain level during a certain period.

Knock-in options: come into existence only if asset price hits barrier before option maturity.

Up and In, Down and In

Knock-out options: die if asset price hits barrier before option maturity.

Up and Out, Down and Out

Parisian Options

They are similar to Barrier Options. In case of Down and Out Parisian Option the asset price will have to remain below the barrier price for at least a pre-determined period for it to be knocked out.

Chooser Option As You Like It

Option starts at time 0, matures at T2. At T1 (0 < T1 < T2) buyer chooses whether it is a put or call. Similar to a Straddle.

Compound Options

Option to buy / sell an option. Have two strike prices and two exercise dates. Four types:

Call on call Put on call Call on put Put on put

These are very sensitive to volatility.

Binary Options

Binary options have discontinuous payoffs.

Cash-or-nothing call:

Pays Q if S > K at time T, otherwise pays 0. Pays S if S > K at time T, otherwise pays 0.

Asset-or-nothing call:

Similar to a Bull Spread but cheaper.

Exchange Options

Option to exchange one asset for another.

Example: An option to buy Yen with Australian dollars for a US based company.

Bermudan Options

Exercisable only on specific dates. Early exercise allowed during only part of life (e.g. there may be an initial lock out period). Strike price changes over the life. The warrants issued by companies often have such features.

Israeli Options

The option writer has the right to cancel the option early at the expense of paying an amount that is lower than the loss that the writer would face if the option is exercised by the holder of option.

Forward Start Options

Option starts at a future time. Most common in employee stock option plans. Often structured so that strike price equals asset price at time T, i.e. at-the-money.

Lookback Options

The payoff from Lookback option depend on minimum and maximum stock price reached during life of option. Often the underlying is a commodity. Lookback call pays ST Smin at time T.

Allows buyer to buy stock at lowest observed price in some interval of time.
Allows buyer to sell stock at highest observed price in some interval of time.

Lookback put pays Smax ST at time T.

Shout Options

Buyer can shout once during option life. Final payoff is greater of:

Usual option payoff, max(ST K, 0), or Intrinsic value at time of shout, St K.

Suppose X = 30 and holder of call shouts when price of stock is 40, then if final stock price is 35 the holder gets 10 and if it is 45 he gets 15. Similar to lookback option but cheaper.

Credit Derivatives

CDs provide a means for transferring credit risk between parties through contracts.

CDS, Total Return Swap, Credit Options.

Contracts can be based on a single credit or on a pool of credits. Can be used for:

Hedging, Speculating and Arbitraging. Mitigating credit exposure. Generate leverage.

Benefits:

Credit Default Swaps

Credit Default Swaps

A CDS is an agreement that the seller of the CDS will compensate the buyer in the event of a loan default. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan.

Credit Default Swaps

Anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). CDS pricing is used as a gauge of the riskiness of corporate and sovereign borrowers. Counterparty Risk in CDS.

Credit Default Swaps

The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of a Company is 50 basis points, or 0.5%, then an investor buying $10 million worth of protection must pay the bank $50,000.

Credit Default Swaps

Total Return Swap

TRS is a financial contract that transfers both the credit risk and market risk of an underlying asset. Bank A owns an asset (e.g. a bond) that periodically gives interest rate payments. Assume that bank A (the protection buyer) and bank B (the protection seller) have entered a total return swap contract.

Total Return Swap

According to this contract, bank A pays all interest payments on the reference asset, plus any capital gains (positive price changes of the asset) over the payment period to bank B. In turn, bank B pays LIBOR plus a spread as well as any negative price changes of the asset. In case of a default of the underlying asset, the asset is valued to zero and bank B has to pay the full initial market price of the asset (which was valid at the start of the contract).

Total Return Swap

Total Return Swap

The TRS allows one party (bank B) to derive the economic benefit of owning an asset without putting that asset on its balance sheet. It allows the other (bank A, which does retain that asset on its balance sheet) to buy protection against loss in its value.

Collateralized Debt Obligations

Weather Derivatives

Performance of many companies is liable to be adversely affected by weather. Weather Derivatives are used to hedge weather risks.

Initially developed in OTC market, now also available as exchange traded instruments. These are priced using historical data. A typical contract provides a payoff dependent on cumulative HDD or CDD during a period.

Weather derivatives are often used by energy companies to hedge the volume of energy required for heating or cooling during a particular month.

Weather Derivatives: Definitions

Heating Degree Days (HDD): For each day this is max(0, 65 A) where A is the average of the highest and lowest temperature in F. Cooling Degree Days (CDD): For each day this is max(0, A 65).

Weather Derivatives: Options

A typical OTC Call Option: On cumulative HDD in December 2006 at the Chicago weather station with a strike of 700 and a payment rate of $10,000 per degree day. These contracts often include payment cap, say, $1.5 million in above case. This is equivalent to a bull spread with long call of strike 700 and short call of strike 850.

Derivative Mishaps

Derivative Mishaps

Huge losses have been caused by activities of certain individuals:

Nick Leeson: Barings Bank. Robert Citron: Orange County. Joseph Jett: Kidder Peabody.

Lessons From Derivative Mishaps

Define risk limits. Take limits seriously.

Do not turn blind eye to high profits if made by exceeding risk limits.

Do not assume you can outguess the market. Carry out scenario analysis.

Lessons For FIs

Monitor traders carefully. Do not blindly trust models. Separation of front office & back office. Recognition of inception profits. Do not sell inappropriate products. Do not ignore liquidity risks. Be careful when everybody is following same trading strategy.

Lessons For NFIs

Make sure you understand trades carefully. Make sure a hedger does not become a speculator. Be cautious about making Treasury Dept a profit centre.