When an FX derivative contract contains additional features above and beyond the basic vanilla option it becomes an exotic FX derivative contract. There are a staggering range of features that can be added: barriers, averages, variable notionals, payoffs returned in a third currency, and so on. Exotic options can also be combined to form popular structures used to hedge FX exposures.
Clients like trading exotic options because they can reflect more precise market views. For example, introducing a barrier that causes the contract to expire if a specified spot level ever trades can make a vanilla option payoff significantly cheaper. By adding a downside knock-out barrier to a vanilla call option the market view expressed by the trade (in isolation) evolves from “spot will be higher at maturity” to “spot will be higher at maturity without having first gone below the barrier level.”
As shown previously, the market price for vanilla options is determined using the volatility surface. Exotic options are priced differently because they cannot be successfully priced using a single adjusted volatility. Instead, a reference price for the exotic contract is generated using the Black-Scholes framework and an adjustment is then calculated. The adjustment takes into account the volatility smile plus other factors not included in the Black-Scholes framework. Pricing models (covered in Chapter 19) are usually used to generate this adjustment.
Exotic options are often ...