One person's exotic option is another person's vanilla. It's time to rewrite our definitions.

By Andrew Webb

In the old days—well, at least a decade ago—life was simple. Anything that wasn’t a standard American or European option on stocks, bonds or currencies fell into the raunchy category of exotic. Exotic options were something to be discussed in hushed, reverential tones, since they were designed (and understood) solely by quants in white lab coats fresh from Defense Department jobs in Ronald Reagan’s Star Wars program.

The market has moved on. Yesterday’s wacky exotic option now elicits little more than yawns, and terms like “vanilla exotic” are even being bandied about. Nowadays there is also much less consensus among market participants as to what constitutes an exotic. One’s definition could depend on various criteria, including correlation, the underlying instrument, the complexity of payoff function or simply the product’s rarity. Different underlying markets make for radically different judgments about what an exotic is: an option that may have become vanilla in the foreign exchange market, for instance, might still be regarded as cutting-edge in equities. There are even individuals who see the term exotic falling by the wayside as the locomotive of derivatives innovation approaches the buffers of customer tolerance. Nevertheless, one thing is increasingly true of all options markets: Weird and wacky are no longer prerequisites of exoticism.

So how do you define an exotic option? To some, the nub of the definition lies in mathematical rigor. “Mathematically, an exotic is something you can’t get away with pricing by using a quick one-factor model,” says Alex Puaca, chairman of derivatives trading and risk management at software vendor DART. “These [models] work for certain products, but not others.” On this basis, he cites an American spread option as an example of an exotic, since using a one-factor model to value it can produce a figure that is adrift by as much as 30 percent. “Correlation is the key here—a one-factor model assumes a correlation of 100 percent between rates, while a large n-factor model allows for realistic correlations, which by implication is exotic,” says Puaca.

Douglass Welch, a vice president at Salomon Smith Barney, also sees correlation, in a broader sense, as a playing a critical role in qualifying for exotic status. “Where you have an option involving cross-correlations between different underlying markets, the big question is how one evaluates the risk/return on multi-asset correlation. The more difficult it is to evaluate, the more I would define the options as exotic,” he says. “I think this is doubly true now—after the way so many long-established correlations broke down in the market upheavals of last fall—since modeling those correlation shifts adds another layer of complexity.”

Welch highlights another popular criterion for exotic options—the number of different payoff functions that they combine. While a straightforward barrier on its own may no longer be considered particularly exotic, combining it with an additional barrier type or other functions probably qualifies as exotic in most books. “Options with more discontinuous payoff functions, where you have to build in various extra layers of functionality—those we would consider exotics,” says Welch. “That’s especially true in higher-volatility markets in which managing that discontinuous payoff is much more of a headache.”

The End Of Exoticism?

There are signs that the exotic revolution may be running out of road. Blithely dreaming up bizarre structures and sticking them to the client base is a defunct business model. Dealers have discovered that clients will only go so far on any date. “In the early days of the derivative industry, things were technology-driven, and doing something new was the priority,” says Michael Bresges, head of European structured marketing at CIBC in London. “Now, development is driven by whether or not a product is appropriate in terms of addressing a particular client problem.” The reasons for this aren’t difficult to find. The derivatives scandals of the mid-1990s have infused a decided wariness and greater appreciation for liquidity into the buyside. Many institutional managers find that any interest they show in exotic structures is quickly curbed by their board of trustees. And this boundary isn’t put up only by clients—regulators are increasingly putting an oar in the water as well. Last summer, for example, the retail sale of digital options on two or more assets was made illegal in the United Kingdom on the grounds that it was too complex a structure to explain to investors. Similar legislation is pending in Germany, while Italy has instead chosen to tax such options more highly by reclassifying them as an income (as opposed to a capital gain) product. CIBC’s Bresges notes that these days many clients are restricted, either by national or internal regulation, to trading what they can model or value themselves. “There is no point in being ahead of the market with a new exotic if the client cannot value it,” he says. As a result of these limitations, there has been a fundamental shift in the way exotics are developed. Although there has always been a lot of lip service paid to addressing clients’ needs, it seems to be absolutely essential when it comes to selling new exotic structures. “There’s no question that the exotics business has become far more client-driven,” says Mark Richardson, head of global equity derivatives at Commerzbank. “You can see that clearly in the way that quantitative research staff are now primarily concerned with developing products in response to client requests rather than simply creating new exotics on an ad hoc basis.” A new generation of exotic options is being developed that appear superficially straightforward but conceal exotic implications. An exotic that has been around for three years and that is fairly typical of this new approach is the spot trader option. In its original incarnation, the option gives the buyer the right to trade spot foreign exchange (such as dollar/yen) daily during the life of the option. At expiry, the option buyer retains any profit made on the foreign exchange trading. If, on the other hand, the trading has resulted in a net loss, the option seller picks up the tab. This basic structure has since been applied to other underlying markets, including stock indices. This product, while relatively simple from the client’s perspective, is something of a nightmare for the seller to hedge. “While the spot trader option is easy to explain to the investor, the seller is faced with a number of complex pricing and hedging problems,” says Chase’s Tim Owens. “Naively, you might wish to incorporate the investor’s probable success rate in calling the underlying market into your calculations, but that’s impractical since there’s no way of hedging that probability of success. In reality, the key to pricing these options correctly is accurately modeling how the volatility smile changes through time.” While it’s theoretically possible to replicate the client’s positions by buying and selling calls or puts on the underlying security, this has the significant disadvantage of exposing the dealer to changes in the volatility surface. The transaction costs can be easily factored into the option premium, but predicting the hedging cost with respect to volatility fluctuations for the same purpose is a rather different kettle of fish. —A.W.

Gerome Miklau, a financial engineer at Monis Software, takes a similar view. “Rarity of the underlying and complexity of payoff are the two qualities that make something exotic,” he says. “Although options may drift from being exotic to vanilla as an increasing number of people are able to model and trade them, the underlying risk doesn’t change—it’s just as complex and just as difficult to manage, regardless of what has happened over last 10 years. Managing something such as binary risk or liquidity risk will always be a challenge, whether you choose to call the option exotic or not.”

A popular alternative definition of exotic relates to how easy a product is to sell. If dealers have difficulty bringing it to market, then by implication it must be exotic. That difficulty could be a result of considerations such as the complexity of the structure, the number and nature of underlying risk factors, the complexity of pricing analytics, or hedging difficulties. In such a case, the market will be small and the bid/ask spread large.

Th FX Breeding Ground

Historically, the foreign exchange markets have been the primordial breeding ground for many of the exotic options that have subsequently made their way into other markets. As a result, to qualify as exotic in the foreign exchange world, an option has to be quite interesting indeed. Foreign exchange is a great market for exotics because it is extremely liquid and because it is always possible to trade the underlying in some time zone or another—virtues that are obvious prerequisites for efficient option pricing and hedging. Equity markets, by contrast, are far less accessible. If you are short an exotic based on a basket of London equities, your window for adjusting your hedge is pretty much restricted to the London Stock Exchange’s opening hours. Foreign exchange exotic options have also traditionally tended to have shorter expiries—more than a year out is relatively rare. By contrast, equity exotics regularly run to eight or more years. As a result, you have longer to live with your nightmares if things go wrong—which has put something of a damper on the adoption of the most exotic options. By the same token, the longer expiry also means that there is a larger window of probability that your worst-case scenario will arise. The net result has been that a particular equity exotic will still probably be elliciting gasps of astonishment long after its foreign exchange equivalent has become the blandest vanilla. —A.W.

Some also see the availability (or lack of) a pricing function as an important yardstick. “If only a few people know how to value an option and sell that information at a premium, distribution will be restricted and the option will therefore be exotic,” says Richard Tanenbaum, a partner at derivatives software vendor Savvysoft. “For example, barriers were considered exotic until the mechanism for valuing them became commonly available. So I think the bottom line is that if you can download from the Internet a free pricing model that gives the right answer, the product in question isn’t exotic.”

“From our perspective, an exotic is anything that isn’t classic vanilla,” adds Chris Dunne, marketing manager for foreign exchange and money at Reuters. “How easy is it to calculate a price, and how readily available are prices in the market? In other words, how exotic can an option be if someone will quote you a two-way market in it?”

“Mathematically, an exotic is something you can’t get away with pricing by using a quick one-factor model.” —Alex Puaca DART

Michael Bresges, head of European structured marketing at CIBC in London, cites systems technology as at least part of the exotic classification. “If an option is processed via the mainstream system on the flow desk, it’s vanilla; if it’s still being handled on spreadsheets, it’s exotic,” he says. Bresges points out, however, that the limitations of the spreadsheet approach also influence the speed with which a successful exotic becomes vanilla. “The transformation may take only a year, or even less, if the volume traded quickly reaches a level at which the spreadsheet approach cannot cope—from a risk management and reporting perspective—and the option has to be transferred to the mainstream [vanilla] system. In general, I think, lead time is getting shorter.”

Quick adoption

The rapid movement of newly minted options from exotic to vanilla status is something of a double-edged sword. On the one hand, the creators of a new exotic can no longer count on recovering their development costs with the first few trades. Advances in generic modeling techniques, such as Monte Carlo, and the falling cost of processing power now allow competitors to price new option variations quicker and more accurately. On the other hand, creators of new options contracts that quickly become vanilla enjoy the minor—although non-pecuniary—satisfaction of knowing that their creations were well-designed and timely enough to become widely traded.

“Quants are now primarily concerned with developing products in response to client requests rather than simply creating new exotics on an ad hoc basis.” —Mark Richardson Commerzbank

One of the most popular exotics of all is the barrier option. (See box, below.) Although they were regarded as exotic when they made their debut in the foreign exchange markets during the 1980s, they quickly became a mainstream way to hedge foreign exchange risk under a precise scenario. “For most people, the standard barrier products are regularly traded and better understood—although perhaps still not always perfectly—so are thus no longer perceived as exotic per se,” says Tim Owens, head of quantitative research and European marketing for foreign exchange options at Chase.

That doesn’t necessarily apply to some of the barrier variants, however. Double barriers are a good example. They may be considered vanilla at major investment banks that already have incorporated them into their mainstream derivatives systems, but outside the upper echelons of the dealer market, they’re more likely to be classified as exotic because of their relative rarity and the problems associated with hedging and valuing them. Another barrier variant that falls into this category is the Parisian option, in which the barrier is “soft” and the trigger for “in” or “out” is based on the number of days the price exceeds (or remains below) the barrier.

The Ubiquitous Barrier

The barrier option, by virtue of its practical value and flexibility, is one of those exotics that has hung around so long and been so heavily used as to become vanilla. In a simple barrier option, there are two important price levels. One is the normal strike price, and the other is the barrier or trigger level. The outcome, if the price of the underlying asset touches or breaks through the barrier level, depends on whether it is an “in” or “out” option. An out option starts life like an ordinary option, but is terminated with extreme prejudice if the barrier level is breached. By contrast, an in option only starts to exist if the barrier is touched. For a call barrier option, the barrier price is commonly fixed below both the current underlying price of the asset and the strike price, hence the terms down-and-in and down-and-out calls. In the case of puts, the barrier is also commonly set out of the money (above both the underlying asset price and strike price), thus giving rise to up-and-in and up-and-out puts. In the case of up-and-out puts and down-and-out calls, the possibility that the option could be terminated before conventional expiry leads to a lower premium than for standard expiry options. While that in itself may be attractive, a better rationale for the use of a barrier is when a user’s strategy is in accordance with the barrier’s characteristics. Historically, this has been particularly true of exporters seeking to hedge their currency risk on a future receivable. For example, a British company might be expecting payment three months ahead on a U.S. export order. Let’s say the current spot exchange rate is $1.6013 and the three-month forward is $1.5896. If the company loses money on the sale if the pound rises above $1.7000, but is happy to sell in the forward market if it drops to $1.5500, a down-and-out call with the barrier set at $1.5500 would fit the bill nicely. If the barrier remains untouched, the option pays out like a conventional call (but for a lower premium) if the pound is above $1.7000 at expiry, and the company is fully hedged. If, on the other hand, the pound drops to $1.5500, the option will be extinguished but the company will immediately execute the forward trade and lock in the foreign exchange gain, less the cost of the barrier premium. —A.W.

At the cutting edge—or beyond the sanity horizon, depending on your viewpoint—there are those options with features so extraordinary that it’s difficult to imagine them as ever being classified as anything but supremely exotic. For example, one Wall Street dealer is reputed to be working on an option with anything up to 1,000 years to expiry, which also includes the right to switch among any one of 20 different fixed-income or equity markets globally.

In the fine print, however, are conditions that give the issuer considerable latitude to restrict the nature and even the cost of keeping the option. Since it is an installment option, many of these conditions relate to the level and frequency of the premium installments payable, so the dealer could (at the risk of permanently alienating the client) theoretically jack these up so the option buyer is effectively forced to abandon it—the ultimate game of exotic chicken.

Real-world valuations

Hand in hand with the ever-fluid definition of exotic has come a shift in valuation attitudes. As the time it takes for an exotic to become vanilla has contracted, the commensurate reduction in available pricing slack has also seen a demand for more accurate modeling.

This hasn’t been driven only by the need to sustain margins. “I think you could safely say that the latter half of the 1990s has seen a perceptible reduction in innovation for its own sake and an increasing focus on refining the pricing of existing instruments,” says Salah Farsi, support manager at Monis Software. “Much of this has been driven by risk management departments, which required such things as better prices, volatility surfaces and the ability to handle discrete dividends. For them, the traditional Black-Scholes assumptions of constant volatility and dividend yield were not acceptable.”

Executive Stock Options: The Most Exotic of Them All

Far away at the other end of spectrum are those options that superficially seem mundane, but on closer inspection are excruciatingly exotic by virtue of their hidden complexity. One classic example is the humble executive stock option (ESO) which has a payoff dependent on a number of well-nigh-impossible-to-model variables. These range from whether the executive gets a better job offer and abandons in-the-money options, to the possibility of a competitor staging a takeover and accelerating the options (reducing their terms), which wouldn’t otherwise be eligible for exercise for another five or 10 years. “That long maturity—10 years is quite common—is in itself a major problem, since you straight away have to start worrying about stochastic volatility and interest rates because it simply isn’t reasonable to think that they will stay the same over that time frame,” says William Margrabe of the William Margrabe Group Inc. “A further complication is that obviously the executives who receive ESOs have some measure of control over the company.” Although the objective in offering ESOs is to provide executives with an incentive to increase the company’s value, it inadvertently provides them with an incentive to increase the volatility as well. Margrabe also highlights the moral hazard issue. “How can you price into the option the likelihood of executives leaving, when only they have the information about whether they are considering doing so? With all these wrinkles, I don’t know of any dealer prepared to make a market in typical ESOs,” he says. —A.W.

As a result, quants are now spending a significant amount of their time testing how well their existing exotic models match up to the real world, and making the necessary changes when they don’t. The events of last fall proved that a number of existing exotic models had developed so quickly that they had not been adequately stress tested. “Some digital and lookback options on South East Asia were examples of this,” says Salomon’s Welch. “Where there used to be five or 10 available counterparties, almost overnight you were lucky if there were one or two. That sudden liquidity shift clearly has a huge impact on the real-world valuation of your exotic. In the textbooks, theory and practice are the same, but what we have witnessed in the real world clearly shows that they are not.”

At present, the prospects for the future of exotic options look good as investors become increasingly eager to enhance yield. It is getting more difficult to find conventional securities with digit returns, and the globe is not awash with stable emerging-market economies yielding 10 percent over Libor. Future developments are likely to come from cross-market products rather than from simply creating more exotic bells and whistles. At the same time, it looks probable that exotics originally developed in foreign exchange will continue to roll out and “vanillify” in other markets.

Whatever the prognosis for exotics, their actual definition looks likely to remain a personal matter, although perhaps also influenced by market and locale. “An exotic option is like pornographic literature,” concludes William Margrabe, president of the William Margrabe Group Inc. “First of all, I may not be able to define it, but I know it when I see it. Second, the definition depends on community standards, which depend on time and place. For example, the unexpurgated version of D.H. Lawrence’s Lady Chatterly’s Lover was available in Florence in 1928 but only reached London in 1960.”

At least exotic options haven’t spawned an obscenity trial—yet.

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