Exotic Options

Mark Rubinstein (1990) is popularized the term "exotic option" in a 1990 working paper (published in 1991, with Eric Reiner). Exotic options generally have features produce greater complexity relative to vanilla equivalents. Payoffs for instance can be defined different and include triggers not typically observed in more standard options. Exotic options can be engineered to meet a specific need of a given clientele. These specific requirements are not readily observable in contracts that trade on an exchange, and exotics are more characteristically traded over the counter (OTC).

Categorizing Options

There is however a tremendous amount of nuance here and Jian Wu and Wei Yu (2010) point out that classification discriminating vanilla from exotic requires some thought and structure. Options can be classified varingly and it is worth exploring factors that help delineate. At a very basic level: European options for instance can be exercised only at the maturity date. This self evidently is different from American options which can be exercised on any date prior to the maturity date. Bermudan options, perhaps more exotically, can be exercised on specific days before the maturity date. Depending on whether the option is traded on an exchange or over the counter, we can distinguish listed options from O.T.C . Even at a very fundamental level relating to the nature of the underlying asset, stock options are distinguishable from "index options”, “interest-rate options”, “currency options”, “commodity options”, “credit options”, “insurance options”, “climate options”, and “electricity options”. Each underlying is somewhat more exotic than the preceding one but we might consider our what constitutes exotic would fall along a continuum and also perhaps a timeline. In future for instance electricity option represent a growing share what today we consider to be normal or pedestrian. We might also consider how "Tailor-made" a given financial product must be to attract investor attention. Or how engineered the product is to respond to specific investor risk predilections. Originally, the term “exotic” was used to describe “Asian options” first appearing in Tokyo, as Japan is perceived as a somewhat “exotic” for Western tastes. Equally, in the early 1700s Australia would have appeared to be beyond the pale for British Isle types. Exotic might therefore imply non-traditional but this would also appear to a be shifting goal post and it is quite likely that what constituted exotic in 1991 might also seem less so by today's standards. In the following pages we will consider a number of valuation models developed binary, barriers, compound options and energy options.