The following topics cover common situations that exotic FX derivative traders come across. Issues around risk management and pricing are investigated, along with how exotic derivatives are used within FX hedging and investment strategies.
Exotic FX derivative contracts are primarily risk managed using the same Greek exposures (delta, gamma, vega, etc.) as vanilla FX derivatives contracts. Therefore, exotic and vanilla FX derivatives in the same currency pair are often risk managed within the same trading position.
When vanilla and exotic contracts are risk managed together it is important that their valuation and Greeks are aligned as closely as possible. Where possible, exactly the same volatility surface (including, e.g., ATM event weights) should be used for all options. If it isn't, risk management becomes more challenging, particularly when exotic risk is hedged with vanilla options close to maturity.
The main additional complication when risk managing exotic FX derivatives comes from barriers (both European and American) close to maturity. For exotic FX derivatives traders the key decisions come around how to hedge barrier risk. There are essentially two possible approaches:
In practice, traders use both approaches. Prior to expiry, when the risk on the exotic is mainly vega-based and Greeks evolve fairly smoothly, vanilla hedges can ...