Ebook Derivatives markets (2nd edition): Part 2
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Ebook Derivatives markets (2nd edition): Part 2
www.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard Ebook Derivatives markets (2nd edition): Part 2 conưacts like these, you obtain a “nonstandard” or “exotic" option. Exotic options can provide precise tailoring of risk exposures, and they permit investment strategies difficult or costly to realize with standard options and securities. In this chapter we discuss some basic kinds of exotic option Ebook Derivatives markets (2nd edition): Part 2s, including Asian, barrier, compound, gap, and exchange options. In Chapter 22 we will consider other exotic options.14.1 INTRODUCTIONImagine that yoEbook Derivatives markets (2nd edition): Part 2
u are discussing currency hedging with Sally Smith, the risk manager of XYZCorp., a dollar-based multinational corporation with sizable European operawww.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard Ebook Derivatives markets (2nd edition): Part 2ance against a fall in the euro but is also interested in exploring alternatives. You have already discussed with Smith the hedging variants from Chapters 2 and 3, including different strike prices, a collar, and a paylater strategy.Suppose that Smith offhandedly mentions that XYZ receives large eur Ebook Derivatives markets (2nd edition): Part 2o payments on a monthly basis, amounting to hundreds of millions of dollars per quarter. In thinking about how to hedge this position, you might reasoEbook Derivatives markets (2nd edition): Part 2
n as follows: “A standard 1-year put option would hedge the firm against the level of the euro on the one day the option expires. This hedge would havwww.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard Ebook Derivatives markets (2nd edition): Part 2 which one option expires every month would have little basis risk but might be expensive. Over the course of the year what really matters is the average exchange rate over tills period; the ups and downs around the average rate cancel out by definition. I wonder if there is any way to base an optio Ebook Derivatives markets (2nd edition): Part 2n on the average of the euro/dollar exchange rate?”This train of thought leads you to construct a new kind of option—based on the average price, ratheEbook Derivatives markets (2nd edition): Part 2
r than the price at a point in time —that addresses a particular business concern: It provides a more precise hedge against the risk that matters, namwww.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard Ebook Derivatives markets (2nd edition): Part 2 not. Generally, an exotic option (or nonstandard option) is simply an option with some contractual difference from standard options. Although we will focus on hedging examples, these products can also be used to speculate.443444£ Exotic Options: IWWW downloadslide comIt is not hard to invent new ki Ebook Derivatives markets (2nd edition): Part 2nds of options. The challenge is to invent new options that are potentially attractive to buyers (which we did in the preceding example) and that canEbook Derivatives markets (2nd edition): Part 2
be priced and hedged without too much difficulty. In Chapters 10 and 13, we saw how a market-maker can delta-hedge an option position. That analysis lwww.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard Ebook Derivatives markets (2nd edition): Part 2when there is a certain relationship among the Greeks of the option.Options withexotic features can generally be priced and delta-hedged in the same way as ordinary options.1 As a consequence, exotic derivative products are quite common in practice and the technology for pricing and hedging them is Ebook Derivatives markets (2nd edition): Part 2well understood. In fact, since many such options are in common use. the term “exotic" is an anachronism. We will continue to use it, however.The goalEbook Derivatives markets (2nd edition): Part 2
in this chapter is not to master the mathematical details of particular products, but rather to gain an intuitive understanding of the ưade-offs in dwww.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard Ebook Derivatives markets (2nd edition): Part 2ptions in minor ways, ordinary options are useful as benchmarks for exotics. To understand exotic options you should ask questions like these:•How does the payoff of the exotic compare to that of a standard option?•Can the exotic option be approximated by some portfolio of other options?•Is theexoti Ebook Derivatives markets (2nd edition): Part 2coption cheap or expensive relative to standard options? Understanding the economics of the option is a critical step in understanding its pricing andEbook Derivatives markets (2nd edition): Part 2
use.•What is the rationale for the use of the exotic option?•How easily can the exotic option be hedged? An option may be desirable to a customer, buwww.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard Ebook Derivatives markets (2nd edition): Part 2 average price over some period of time. An Asian option is an example of a path-dependent option, which means that the value of the option at expiration depends upon the path by which the stock arrived at its final price? Such an option has the potential to solve XYZ’s hedging problem.'However, as Ebook Derivatives markets (2nd edition): Part 2we will see in Chapter 22, there are options that are quite difficult to hedge even though they arc easy to price.2You can think of path dependence inEbook Derivatives markets (2nd edition): Part 2
die context of a binomial pricing model, in the binomial model of Chapter 10. ttdu and dull arc a scries of up and down stock price moves—paths—occurwww.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard Ebook Derivatives markets (2nd edition): Part 2dependent option, these two paths would yield different final option payoffs because the intermediate stock prices were different.www.downloadslide.com A5|AN 0pT There are many practical applications in which we average prices. In addition to cases where the firm cares about the average exchange rat Ebook Derivatives markets (2nd edition): Part 2e (as with XYZ), averaging is also used when a single price at a point in time might be subject to manipulation or price swings induced by thin marketEbook Derivatives markets (2nd edition): Part 2
s. Bonds convertible into stock, for example, often base the terms of conversion on the average stock price over a 20-day period at the end of the bonwww.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard Ebook Derivatives markets (2nd edition): Part 2ian options are worth less at issuance than otherwise equivalent ordinary options. The reason is that the averaged price of the underlying asset is less volatile than the asset price itself, and an option on a lower volatility asset is worth less.XYZ’s Hedging ProblemLet's think more about XYZ's cur Ebook Derivatives markets (2nd edition): Part 2rency hedging problem. Suppose that XYZ has a monthly euro inflow of €100m. reflecting revenue from selling products in Europe. Its costs, however, arEbook Derivatives markets (2nd edition): Part 2
e primarily fixed in dollars. Let .V, denote the dollar price of a euro in month i. At the end of the year, the converted amount in dollars is12€100m www.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard Ebook Derivatives markets (2nd edition): Part 2acts: Sell euro forward contracts maturing each month over the year. The premium of this strategy is zero.•Euro swap: Swap euros for dollars. We saw in Chapter 8 that, except for the timing of cash flows, a swap produces the same result as hedging with the strip of forwards. A swap also has a zero p Ebook Derivatives markets (2nd edition): Part 2remium.•Strip of puts: Buy 12 putoptionson€ 100m, each maturing attheend of adifferent month. The cost is the 12 option premiums.As we saw in ChapterEbook Derivatives markets (2nd edition): Part 2
2, the difference between the forward and option strategies is the ability to profit from a euro appreciation, but we pay a premium for the possibilitwww.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standard www.downloadslide:GỡmCHAPTER 14Exotic Options: I-Ấ. hus far we have discussed standard options, futures, and swaps. By altering the terms of standardGọi ngay
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