What are Exotic Options / Vanilla Options ?

An exotic option is a derivative which has features making it more complex than commonly traded products (vanilla options). These products are usually traded over-the-counter (OTC), or are embedded in structured notes.
An exotic product could have one or more of the following features:
* The payoff at maturity depends not just on the value of the underlying index at maturity, but at its value at several times during the contract’s life. It could be an Asian option depending on some average, a look-back option depending on the maximum or minimum, a barrier option which ceases to exist if a certain level is reached or not reached by the underlying, a digital option, range options, etc.
* It could depend on more than one index; as in case of a basket options, Himalaya options, or other mountain range options, outperformance options, etc.
* There could be callability and putability rights.
* It could involve foreign exchange rates in various ways, such as a quanto or composite option.
Similarly there are few more important types for classification:

Barrier Options - They let the investor gain from their expectation of share price path movement, for example, the share will first go down and then Rocket up.
There are several types of barriers:
(a) Binary option
They are options with discontinuous payoffs. Another type of binary option is an asset or nothing call. This payoff nothing if the underlying asset price ends up below the strike price and pays the asset if it ends up above the strike price.
(b) Asian Options
They are a type of averaging option. Most common is to average the share price. The pay out is determined by deducting the average from the strike. This option is far cheaper because the volatility of an
average is lower than that of the price itself.
(c) Compound Option
It is an option on an option. Here, the holder has an Call option that expires 10th March to purchase a Call option for £2.00 which
will then give the holder the right to purchase the shares at £12.00 on 31st October.
The holder pays less up-front,thus effectively making this a highly geared instrument.

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What are Exotic Options / Vanilla Options ?

 

An exotic option is a derivative which has features making it more complex than commonly traded products (vanilla options). These products are usually traded over-the-counter (OTC), or are embedded in structured notes.
An exotic product could have one or more of the following features:
* The payoff at maturity depends not just on the value of the underlying index at maturity, but at its value at several times during the contract’s life. It could be an Asian option depending on some average, a look-back option depending on the maximum or minimum, a barrier option which ceases to exist if a certain level is reached or not reached by the underlying, a digital option, range options, etc.
* It could depend on more than one index; as in case of a basket options, Himalaya options, or other mountain range options, outperformance options, etc.
* There could be callability and putability rights.
* It could involve foreign exchange rates in various ways, such as a quanto or composite option.
Similarly there are few more important types for classification:

Barrier Options - They let the investor gain from their expectation of share price path movement, for example,  the share will first go down and then Rocket up.
There are several types of barriers:
(a) Binary option
They are options with discontinuous payoffs. Another type of binary option is an asset or nothing call. This payoff nothing if the underlying asset price ends up below the strike price and pays the asset if it ends up above the strike price.
(b) Asian Options
They are a type of averaging option. Most common is to average the share price. The pay out is determined by deducting the average from the strike. This option is far cheaper because the volatility of an
average is lower than that of the price itself.
(c) Compound Option
It is an option on an option. Here, the holder has an Call option that expires 10th March to purchase a Call option for £2.00 which
will then give the holder the right to purchase the shares at £12.00 on 31st October.
The holder pays less up-front,thus effectively making this a highly geared instrument.

Pristine Careers
More than 250,000 Man hours of Quality Training
* One stop for Financial Trainings View Details
* Innovative Content Visualize FRM Diagnostic FRM
* Question Solving Sessions View Details
* Topic Expert Model Learn from the
* Masters of the Trade View Detail
* It is no wonder that 53%  of our new students come  from recommendation of old  students

VaR Methodology: Shortcomings

 

 
What is the most I can lose on this investment? This is a question that almost every investor who has invested or is considering investing in a risky asset asks at some point in time. Value at Risk tries to provide an answer, at least within a reasonable bound.
It gives the likelihood that a portfolio will suffer a large loss in some period of time, or the maximum amount that you are likely to lose with some probability (say, 99%).
It finds this by :
(1) looking at historical data about asset price changes and correlations;
(2) using that data to estimate the probability distributions of those asset prices and correlations; and
(3) using those estimated distributions to calculate the maximum amount you will lose 99% of the time.
But the things are not as simple as that. Real markets don’t go by statistics or rules of probabilty.

You must read this elegant article by Joe Nocera that talks about Var inlight of the sub-prime mortgage crisis. Here is interesting excerpt:
“At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives. It made black swans [unlikely events] all the easier to ignore. All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. After all, it would end badly for everyone else too. ”
So, here is what’s wrong with the approach:
* Tendency to assume Normal distributions, and thus low probability of ‘extremes’. Reality is that financial returns are more skewed than normality suggests - excessively high and low return days are far more common than would be expected;
* There is often an assumption that history repeats itself, or, the past can predict the future;
* VaR does not describe the losses in the extreme left “tail” of the distribution. (Conditional VaR can help to measure “the expected loss, given the loss exceeds VaR”)
* VaR does not distinguish portfolio liquidity; very different portfolios can have the same VaR i.e. VaR is a static measure of risk and does not capture the dynamics of possible losses if a portfolio were to be unwound;
* Computations can be very complex; there is model risk; precision should not be assumed;
* VaR-constrained traders can game the system i.e. maximize risk subject to keeping VaR steady. The game repeats itself at several levels; and can trigger an avalanche, because everyone misjudges risk in the same way.
Is VAR the Right Methodology? In many situations, VAR may not be the correct risk-management methodology. If we pick a specific loss such as $1 million, VAR allows us to estimate how often we can expect to experience this particular loss. For example, using VAR we might estimate that we will lose at least $1 million on one trading day in 20, on average. During some 20-day periods, we might lose less than $1 million. During other 20-day periods, we might lose more than $1 million on more than one day. VAR tells us how often we can expect to experience particular losses. It doesn’t tell us how large those losses are likely to be.
GARP


Pristine Careers
More than 250,000 Man hours of Quality Training
* One stop for Financial Trainings View Details
* Innovative Content Visualize FRM Diagnostic FRM
* Question Solving Sessions View Details
* Topic Expert Model Learn from the
* Masters of the Trade View Detail
* It is no wonder that 53%  of our new students come  from recommendation of old  students