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Exotic Options

An exotic option is a kind of derivative which has features making it more complex than commonly traded products which are known as vanilla options. These products are usually traded over-the-counter (OTC), or are embedded in structured notes. Before learning about exotic options, we should have a good understanding of regular options. Both type of options the right to buy or sell an asset in the future, however the way investors realize profits using these options differs dramatically.

 

Difference between Exotic Option & Regular option

An exotic option is a type of option other than the standard calls and puts found on major exchanges. An investor who buys a call option has actually bought a standardized right to purchase a specific amount of an underlying asset at the agreed upon strike price, while a put option gives the investor the right to sell the specific asset at the strike when the price of the underlying decreases. These regular options are also known as plain vanilla options. Exotic options can be quite different, as the below examples show:

Chooser option: It gives the investor the right to choose whether the option is a put or a call at a certain point during the option's life. Unlike regular options that are purchased as a call or a put at initiation, these exotic options can change during the life of the option.

 

Barrier option: An option whose payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price is known a barrier option. The right to purchase the underlying at an agreed strike price only realizes when the price hits the agreed upon 'barrier'. This is unlike a regular option because the holder of a vanilla (regular) option can buy the underlying at the strike price at any time after inception.

 

Asian option: Anyone who invests in regular options will prove to their volatility. An Asian option provides a good way to reduce this volatility. These exotic options have a payoff which depends on the average price of the underlying asset over a certain period of time as opposed to at maturity.

 

Note: However the types of exotic option are explained below.

 

The final difference between exotic options and regular options has to do with how they trade. Regular options consist of calls and puts and can be found on major exchanges such as the Chicago Board Options Exchange. Exotic options are mainly traded over the counter, which means they are not listed on a formal exchange, and the terms of the options are generally negotiated by brokers/dealers and are not normally standardized as they are with regular options.   

 

Features of exotic Option  

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, peroni options, range options, etc.)

·         It usually depends on more than one index (as in a basket options, Himalaya options, Peroni options, or other mountain range options, outperformance options, etc.)

·         There could be callability and putability rights which form the types of basic option.

·       It involves foreign exchange rates in various ways, such as a quanto or composite option.

 Types of Exotic Options:

·         One-touch options

·         No-touch option

·         Double one-touch

·         Double no-touch

·         Digital options

·         Asian options

·         Balloon options

·         Basket option

·         Digital Option

·         Barrier options

·         Embedded Option

·         Lock-out option

·         Look-back option

·         Single-barrier options

·         Double-trigger option

·         Weather options

 

One-touch options

A one-touch option is one of the most popular exotics that are profitable if the price of the currency pair touches a specified price within a certain period of time. Timing is especially significant with exotic options. Each broker may have different cut-off conventions but exotic options are timed against the New York cut-off, which is 10 a.m. ET. However, some brokers will set the cut-off time at 24:00 GMT (4 a.m. ET), so it is necessary to confirm the time before making a trade.

 

One-touch options are usually used for conditions when there is a strong opinion about the direction of a currency pair and you are convinced the move will happen soon. A one-touch option with a far-away target (perhaps 200 pips away) and a very short time span (24 to 48 hours) will have a very high reward-risk ratio (typically 3:1 or less) precisely because there is seldom any payout for such trade.

 

No-touch option

No-touch options are profitable only when the price of a currency pair does not reach the target by a specified time. A no-touch option offers better payout odds when the strike price is closer to the market price but the expiration date is farther away because the chances the currency will not touch the strike price diminish considerably the longer the trader has to wait. One interesting factor of the no-touch is the fact the underlying currency pair does not have to move away from the strike price in order to produce a profit. The currency pair simply has to stay relatively stagnant for the trader to collect a payout.

 

Double one-touch

In double one-touch option you can select two strike-price barriers that provides a payout if either one is touched. The double one-touch is similar to a standard long strangle or straddle option trade and it is a good tool to use when you have no strong opinion about direction of the price movements but you expect volatility to explode.

 

Double no-touch

The double no-touch option is just the opposite of the double one-touch. It is appropriate for situations in which you anticipate a range-bound market where there is no clear indication about the direction and expect volatility to be low.

 

One-touch and no-touch options are precisely time sensitive. A one-touch will be significantly cheaper the less time there is to expiration because the odds of reaching the target is greatly reduced, while a no-touch will be priced opposite to one-touch because the chances of not touching the target will diminish the more time is left on the contract.

 

However, the double one-touch and double no-touch options will have the same pricing parameters in terms of time but will vary greatly with respect to the volatility. Double one-touch options, for example, will become progressively more expensive as the barriers narrow.

 

Digital options

Digital options produce a payout only if the spot price meets or exceeds the selected barrier price at expiration. Digital options are less expensive than one-touch options with the same strike and expiration date whereas Digital premiums can be half the price of no-touch options premiums with the exact same strike price and expiration dates, but the trader has to weigh the advantage of lower cost against the risk price will settle even 1 pip below the target at expiration.

 

Asian options

Asian options are options in which the average price over a period of time is the underlying variable. Because of this, Asian options have a lower volatility and hence are rendered at cheaper relative to their European counterparts. They are commonly traded on currencies and commodity products having low trading volumes.

 

They are divided into three categories; arithmetic average Asians, geometric average Asians and both these forms can be averaged on a weighted average basis, whereby a given weight is applied to each stock that is being averaged. This is used for attaining an average on a sample with a highly skewed sample population.

 

Balloon options

An option whose notional payments increase significantly only after a set threshold is broken. It is commonly used in foreign exchange markets and these options provide greater leverage to the holder. The main idea behind the balloon option is that after the threshold is exceeded, there is an increase in regular payout.

 

Barrier options

Barrier options are path-dependent options which appear in many flavours and forms, but their key characteristic is that these types of options are either initiated or exterminated upon reaching a certain barrier level; they are either knocked in or knocked out.

 

Basket option

A basket option has all the characteristics of a standard option, except that the strike price is based on the weighted value of the component currencies which is calculated in the buyer's base currency. The buyers order the maturity of the option, the foreign currency amounts which make up the basket, and the strike price is expressed in units of the base currency.

 

At expiry, if the total value of the component currencies in the spot market is less favourable than that of the strike price of the basket option the buyer would let the option lapse. If it is more favourable, the buyer would exercise the option and exchange all of the component currencies for the pre-specified amount of the base currency (i.e. the strike price of the option).

 

Digital Option

An option whose payout is fixed only after the underlying stock exceeds the predetermined threshold or strike price is known as Digital option. It is also known as "binary" or "all-or-nothing option."

 

Embedded Option

An option which is an inseparable part of another instrument is known as embedded option. A common embedded option is usually the call provision in most corporate bonds.

 

Lock-out option

A lock-out option pays only if the value of the underlying does not go beyond a specified value whereas a double-lockout option pays if the value of the underlying asset remains confined within a specified range.

Look back option

A look back option pays depending on the highest value reached by the underlying during the contract period. Some of the look back options use the highest value reached by the underlying during the contract period to determine the amount of settlement. One formula for the lookback is:

 

Look back = Maximum (Spot Price at Expiration – Minimum Spot Price over Term of Contract, or 0)

 

Single-barrier options

Single-barrier options are options which have a single trigger price that is either above or below the strike price whereas double-barrier options have trigger prices that are above and below the strike price. Because the option may either not come into existence or pass out of existence, barrier options are generally cheaper than the standard options but the double-barrier options are the cheapest.

 

Double-trigger option

A double-trigger option, often used for insurance purposes, pays off when 2 events occur. A company or an insurance company will buy this option to limit losses that are unlikely, and it would be very expensive if they both occur. An example would be if a company had a large property loss in a foreign country due to changes in the foreign exchange rate made the loss much more expensive.

 

Weather options

Weather options pay off only for unusual weather. Many businesses that are affected by the weather, such as utilities and ski resorts, use these options to keep cash flow more consistent.

 

Exotic options are frequently used to make the price of options (and hedging) cheaper, by excluding some opportunities for exercise but one must notice to beware as Exotics can be complex, expensive and hard to understand (i.e. involve high gearing).

Promoters may lose pledged shares if rally fizzles out

Scores of medium-sized companies' promoters face the risk of losing their pledged shares for failing to meet margin calls like Orchid Chemicals' Raghavendra Rao in 2008, as the Bombay Stock Exchange'smid-cap gauge has lost nearly a quarter of its value since peaking in November.

A few days of rally, such as the one on Monday when the BSE's Mid-Cap Index rose 3.5%, could prevent a sell-off though.

Promoters of Unitech, once the second-biggest real estate developer, were on the verge of losing some of their shares, but salvaged the situation at the last moment before the lenders sold them off. There have been a couple of such instances, but the companies involved have been very small.

"The worry about company promoters facing margin calls for their pledged shares is very real because funding has tightened in the last three months," said Saurabh Mukherjea, head of equites, Ambit Capital.

"If the market sees another major sell-off, the situation could turn worse especially for those promoters who have already pledged a sizeable chunk of their holdings."

Promoters of companies during a bull run are lured by lenders with attractive funding against their shares. They use these funds to build more factories, or just to speculate in the market. Initially, they reap big trading profits, but when the market turns around, some, such as Vijay Sheth of Great Offshore, are so highly leveraged that they lose their companies built over decades.

The speculation about companies were so rife in the last bear market that the Securities and Exchange Board of India , or Sebi, mandated promoters to disclose their pledges.

The recent crash has led to many lenders seeking more collateral since the value of the assets pledged have eroded in the sell-off in the last two months as foreign funds pulled out about $1.5 billion.

Recently, Morgan Stanley decided to sell property developer Unitech's shares after the company founder's entities could not bring in more shares to make up for the short-fall in margin.

"Pledged shares of many promoters are close to their threshold limit of margin calls," said an executive at a lender who did not want to be identified.

"Any sharp fall from these levels can trigger selling.We have already asked some promoters to ready up to meet additional margin calls."

Four leading brokerages suffered losses after funding entities of a Mumbai-based entertainment company, whose shares tumbled in the recent sell-off.

They had lent about Rs150 crore against shares that were then valued at Rs 300 crore. When the value of the collateral fell in the wake of the recent market fall, these friendly brokers could not bring in more shares.

Part holdings of a Chennai-based media company's promoter were also sold off by a New Delhi-based lender recently for failing to bring in additional margins.

"Whenever there is a 10-15% fall in the markets, there is always margin pressure for stocks pledged in the mid-cap space," said Avnash Gupta, VP-research, Bonanza Portfolio.

"Apart from promoters, many high net worth investors also take positions in the market against their shares. As of now, there are not many companies under severe pressure from selling apart from companies in the real estate sector, whose balance sheets are strained. Investors should stay away from companies where promoter holding is low and high percentage of shares are pledged." 

Citi: 50 Per Cent Of India's Economy Comprises Black Money or $640 Bn; Annual Illegal Outlfows $ 104 Bn

India's Underground Economy-Worth $ 640 Bn and Growing

Most of this money goes into Land deals, Bullion, greasing bureaucracy for licensing deals and ultimately depriving millions off affordable housing. The Bank-Real Estate Nexus also needs to be examined thoroughly-who knows what the Land Barons are cooking up.

Illicit Income: Back in the Limelight — The recent fracas over unaccounted money parked overseas has resulted in a renewed focus on 'black' or unaccounted money flows from India. While Germany has provided the names of 26 Indians with secret accounts in LGT Bank in Liechtenstein, the Indian government has since come under fire from both the judiciary as well as opposition parties for not taking action against the people involved. 

However, the government has said that in the absence of a bilateral treaty with Liechtenstein, India cannot seek any administrative assistance on Indian clients of the LGT Bank. Efforts are currently underway to sign a Tax Information Exchange Agreement (TIEA) with Liechtenstein which would aid disclosure, but Liechtenstein is negotiating a Double Taxation agreement (DTAA).

Gauging the Quantum: Illicit Flows are a Growing Worry — The issue of illegal flows is not new. A recent study by Global Financial Integrity (GFI) estimates the present value of total illicit flows at US$462bn, while a BJP Taskforce report in 2009 puts the quantum anywhere between US$0.5-1.4trn.

On an annual basis, GFI indicates that India lost assets at the rate of US$19bn each year. These flows are typically the result of tax evasion, corruption, bribery, kickbacks, and terrorist activities. While the cause of illicit flows is attributed to structural and governance issues, an interesting finding by GFI was that liberalization of trade and deregulation actually led to an increase in illicit flows! While this is counter intuitive, GFI attributes this to slow progress in strengthening of institutions governance, consequently resulting in misinvoicing and the presence of a large underground economy.

Macro Implications & What Is Being Done? — Curbing tax evasion and efforts to bring back illicit flows overseas would positively impact both Public Finances as well as the Balance of Payments (via the remittance route). In addition to signing a bilateral treaty with Liechtenstein, efforts are also currently underway to access Swiss Accounts. Earlier this month, the Indian government adopted a 5-fold strategy which comprises playing a proactive role in the global crusade against illicit funds and creating an appropriate legislative framework including setting up overseas tax units. India currently has DTAA with 79 countries and is working towards modifying the articles concerning exchange of banking information. In the recent past, India has implemented preventative measures for money laundering, terrorist financing, and financial activities in line with FATF standards. While government efforts are showing some results (in the last 18 months the government detected undisclosed income over Rs150bn, the Directorate of International Taxation has collected taxes of Rs346bn, and the Directorate of Transfer Pricing has detected mispricing of Rs338bn), more needs to be done to address the annual loss of assets overseas via illicit flows. 

Credit Suisse-India Sensex To Undershoot 16000

Negative momentum to last till June 2011, Sensex likely below 16000

We believe there are three major concerns for the market currently: 1) High inflation, which it is feared that the RBI can only control by further slowing growth; 2) Policy paralysis by the government in terms of reforms and administrative decision-making is causing inordinate delays in the much-needed improvements in physical, financial and social infrastructure; and 3) Anecdotal evidence continues to suggest a weakening economy even before interest rate increases impact businesses.

3Q11 earnings were disappointing on the whole, with very few sectors seeing earnings upgrades. In fact, most of the 'local' sectors have seen sharp cuts in forecasts.

 
We believe the shift in location of growth momentum is additive, and materially strengthens the medium-term growth potential for India: with a 12% lower industrial ICOR (2004-08), under-developed states can deliver stronger growth with the same capital. That said, it does not preclude cyclicality in the overall economy, and the under-developed states are not yet large enough to offset a slowdown in the developed states.  

This will continue to impact the stock market – GDP growth and market multiples are strongly correlated. Worse, we believe the slowdown would 'feel' worse than reality, as the economic bell-weather sectors (construction, cement, real estate) are 'local' in developed states. They are an insignificant 3% of the Nifty EPS but by influencing perception of how well the economy is doing, have a much more significant impact on the market.

 
This is likely to be exacerbated by fund flows – we estimate only about 20% of the ETF and 2% of non-ETF FII flows seen in 2010 have reversed YTD. The market may languish till mid-CY11, falling to 16,000 levels. We would avoid 'local' sectors.