Exotic options

Discussion in 'P2.T5. Market Risk (25%)' started by Hend Abuenein, Jan 30, 2012.

  1. Hend Abuenein

    Hend Abuenein Active Member

    Hi David,

    About floating lookback options, would it be correct to say that these options give the owner the opportunity to purchase/sell the stock at its lowest/highest price over the life of the option, given that these prices cannot be determined ex-ante ?

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  2. David Harper CFA FRM

    David Harper CFA FRM David Harper CFA FRM (test) Staff Member

    Hi Hend,

    I hadn't thought of them that way but Hull agrees (nice!):

    Also consistent is Peter James (a favorite from my library on exotics; Option Theory), emphasis mine:

    now that you mention it, frame it this way, it kind of reminds me of a certain variety of non-qualifed employee stock purchase plan (ESPP) where employees could purchase at the lowest trailing price over a window (and/or 15% discount) but that's in the ESO category i guess, so that's a flawed comparison (I guess you don't hold onto the stock with the lookback, but rather receive the cash payoff).

    Interesting! Thanks
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  3. Hend Abuenein

    Hend Abuenein Active Member

    Thank you for the quotes.
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  4. LeeBrittain

    LeeBrittain Member

    Hi David,

    I tried to create a new thread for my following question but the site wouldn't allow me to... I click "post new thread", entered my subject title but no box became available to enter a message. Is the system down or am I missing where to post a new topic?

    Anyways, my question is on the shape of the volatility smile when there are asset price jumps. In the notes it says that asset price jumps tend to lead to a volatility frown due to the bimodal distribution, but in the practice questions (18.03) it shows an implied smile with jumps in the underlying. Am I missing something here or are those contradictory answers?

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  5. David Harper CFA FRM

    David Harper CFA FRM David Harper CFA FRM (test) Staff Member

    Hi Lee,

    I asked our developers to look into the thread issue: we are able to replicate in firefox, so THANK you. I'm confident they can fix.

    With respect to Hull's apparent conflict, I totally agree (18.03 is his question). I frankly have not resolved it. From a merely practical matter, I can tell you that question 18.03 is clearly the "correct" and useful view (i.e., jumps are meant to connote a heavy tailed distribution and therefore a smile not a frown).

    Contrast with Hull's final section on a single large jump. I think (but am unsure) that the difference is a bimodal distribution with possibility of kurtosis < 3, however, I'm unclear (b/c I also think the mixture of 2 lognormals must be heavier tailed than 1, but have not researched) .

    All i can get is that his point seems to be that unusual distributions imply, and here are his words, "an unusual volatility smile." So my best guess is that his example just happens to imply a frown but that we could generate other bimodal/mixtures of lognormals that produced a smile. I apologize I cannot say with any certainty. Thanks again for floating the bug,
  6. Hend Abuenein

    Hend Abuenein Active Member

    Hi David,
    I hope you're doing well.

    1- A few questions in GARP's practice exams compare prices of exotic options. The answers I've come across relied on two factors: flexibility given to investor, and European always being cheaper than exotics.
    What else is there to consider when comparing for exotic options' values? What makes a barrier option cheaper/more expensive than an Asian or a lookback option, for example?

    2- Up/Down and out options are known to have a negative vega, because the higher volatility of the underlying nears its price to the out barrier.
    A question in GARP's 2008 practice exam compares a deep ITM to a deep OTM up and out call option asking which has a negative vega (other choices irrelevant).
    The answer was that it's the deep ITM up and out call since the higher volatility would risk option exiting barrier or loosing its moneyness.
    But why doesn't the same analysis apply to the OTM call?
    If the barrier is near K (sensible to a call), and S is much below K (since it's OTM), investor would want S to be increased by high volatility in order to gain moneyness only if it weren't a barrier option. The barrier would make the investor value the option less with the higher volatility.

    Am I getting something wrong here?

    Thank you
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  7. David Harper CFA FRM

    David Harper CFA FRM David Harper CFA FRM (test) Staff Member

    Hi Hend,

    Thanks, I hope you are doing well, too!

    1. That's interesting, we really should add this perspective to the questions/notes; i.e., key dimensions for evaluating exotics. First, I am not aware that general comparisons can be made among exotics; e.g., I am not aware if we can generalize that a lookback would be less or more valuable than chooser, as both have additional features that make them more valuable than Europeans. We could only do so, to my knowledge, for example, comparing a lookback to a barrier because, in general, lookback > plain vanilla Euro > Barrier, so by syllogism.
    (what is the right word to describe the conclusion that a>c, if a>b and c < b??, I must be tired)

    I think some noticeable feature dimensions are:
    • restrictions/forfeitures: e.g., both barrier and employee/executive options take an option and restrict some of the optionality, which reduces its value
    • additional options on the options; e.g., chooser adds an option on top of an option, increases value
    • pricing frequencies: if a lookback averages prices, increasing frequency adds value.
      (just my top thoughts, not comprehensive, i think each exotic needs to be considered on its own)
    2. Interesting, I had to look this up. See below. With the benefit of this reference, i can see see the intuition if we (per Hull) decompose the up and out call as:
    c(up and out) = c (Euro) - call (up and in);

    An increase in volatility has two opposing influences:
    Higher vol --> Higher value of a vanilla c(Euro), however
    Higher vol --> Higher value of the call (up and in)

    De Weert is making sense to me in that he's saying that, for an OTM up and out, the first effect dominates, but gives over to the second effect dominating for an ITM (keep in mind, the higher intrinsic value isn't really impacting. Vega is change in volatility, keeping everything else same, so it's really volatility impact on the time value of money). Interesting questions, for sure, I hope that helps b/c I sure learned something here. Back to practice questions for me!

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