The term ‘exotic option’ is a rather loose one, but it is conventionally used to describe later generation options whose terms differ in some way from the standard terms of a vanilla call or put option. This Appendix describes briefly some of the key structures used in the markets.
Asian or average price options
The payoff from an average price call is zero or the average price of the underlying over a predetermined period of time minus the strike, whichever is the greater. The payoff from an average price put is zero or the strike minus the average price of the underlying over a set period of time, whichever is the greater.
Asian options are generally less expensive than conventional options since averaging prices over a period of time has the effect of lowering volatility. The more frequently the averaging is carried out the greater this effect, so that daily averaging reduces volatility more than weekly or monthly averaging. For the same reason geometric averaging reduces volatility more than arithmetic averaging.
A further variant is the average strike option. Here the price of the underlying over some period of time is averaged out and the strike price is set to that average. The payout of an average strike call is zero or the difference between the price of the underlying and the strike on exercise, whichever is the greater.
The payoff from a barrier option depends on whether or not the price of the underlying reaches a certain ...