Chapter 12
Another class of options that is becoming increasingly important in the investment banking industry is the so-called ‘exotic option’. The reason that this type of option is called an ‘exotic option’ is because the variables that determine the price of this option are not only the usual variables like stock price, strike price, interest rate, dividend and stock volatility but also variables like foreign exchange (FX) volatility or correlation between the stock price and a specific foreign exchange rate. In other words, when an investment bank executes a deal that involves an exotic option both the client as well as the investment bank expose themselves to more variables than when executing a deal involving only a plain vanilla option.
This chapter will only discuss two types of exotic options: the quanto option and the composite option.


The quanto option is designed for investors who want to execute an option strategy on a foreign stock but are only interested in the percentage return of that strategy and want to get paid this return in their own currency. The basic principle of a quanto option is that the exchange rate will be fixed to the prevailing exchange rate at inception of the option transaction and the payout of the quanto option will be this exchange rate times the payout of the regular option.
Consider a U.S. investor who is very bullish on the share price of BP (British Petroleum). For that reason this U.S. ...

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