What are Exotic Options?
As the word represents, Exotic options are the options that are used rarely and are highly customised. Exotic options are the opposite of plain vanilla options, generally traded on exchanges in fairly liquid markets. Hedging is traded in the OTC market and meet a specific firm’s need for Hedging that plain vanilla options typically cannot meet. The main objective behind building these options is to provide a unique and customised hedge for a firm’s needs.
There are several classic examples of them. The gap option is an example in which the concept of trigger price gives a gap in the cashflows.
Why is it essential to know about them?
- provide more efficient Hedging than plain vanilla options
- reflect a firm’s view on interest rates, exchange rates, and commodity prices
- Useful for tax or regulatory purposes
In addition to the benefits mentioned above, exotic options can allow traders to take advantage of unique market conditions and profit from market inefficiencies. These options can also provide greater flexibility in managing risk than traditional hedging instruments, such as futures contracts or standard options.
However, in contrast to standard options, exotic options come with greater individualization, making them more difficult to price and trade. This complexity requires a deeper understanding of the underlying asset and the option’s specific features. As a direct consequence, skilled traders and financial institutions are the most common main parties in the trading of exotic options.
Exotic options are often useful in cases where the risks are highly specific and need customization as an approach for effective hedging. They are highly useful for complex investment portfolios where a traditional hedging instrument may not be adequate. For instance, consider a portfolio of highly illiquid assets like real estate. Hedging such a portfolio with traditional instruments like futures or options can be challenging due to their highly customized nature. However, with exotic options, it is possible to create a hedging strategy that better reflects the risks in the portfolio and provides more effective protection.
They are also highly flexible, and you can tailor them to meet the unique needs of a particular investor. This flexibility comes in handy when traditional hedging instruments may be too rigid and not well-suited for specific risk exposure. By creating customized options contracts, investors can better manage their risks and improve their portfolio’s overall performance.
In conclusion, exotic options offer a high customization hedging and risk management approach. They are not traded on exchanges and are often used for highly specific purposes. However, they can be highly effective in managing complex portfolios and specific risk exposures. While exotic options may not be suitable for every investor, they are essential for those needing a more tailored risk management approach.