Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

CHAPTER 12

Managing Exotic Options Risk

We need to first determine what we mean by an exotic option. Some articles on options emphasize complex formulas and difficult mathematical derivations as the hallmarks that distinguish exotics from vanillas. The criterion I am using in this book emphasizes market liquidity. If you can readily obtain prices at which the option can be bought and sold, then it counts as a vanilla option; if not, then it is an exotic option.

To understand why I favor this definition, consider a forward-start option as an illustrative example. This is an option priced now, but its strike is not set until some future date. Generally, it is set to be at-the-money on that future date. There is certainly no complexity about the formula or mathematical derivation of the formula for this product. It is the standard Black-Scholes formula with the strike and underlying price set equal. However, this product has no liquid market, and relating its valuation and hedging to the valuation and hedging of ordinary European options is not straightforward. Equivalently, we can say that no clear relationship exists between the volatility that is needed as input to the Black-Scholes formula for the forward-start option and the volatilities implied by the prices of standard European options.

The two preceding chapters, on managing forward risk and vanilla options risk, emphasized the use of methods that maximize the degree to which all transactions can be viewed as being managed ...