Exotic Options

This course forms module 2 of the Options Training Week. Notwithstanding the global financial crisis, constant innovation within the derivatives marketplace continues to see the evolution of new, exotic derivatives, fuelled in part by the growth of structured products across traditional and alternative asset classes, and the increasing use of exotic derivatives within corporate and institutional applications. Exotic derivatives have become commonplace in the engineering of such innovative structures, lowering costs and increasing the flexibility in tailoring risk profiles to suit end user views and expectations. Exotic options present some unique challenges in respect of pricing and valuation models and methods, transparency, and in their risk characteristics and risk management techniques. This unique 2 day programme provides a robust and practical understanding of exotic options – price modelling, hedging and replication techniques, and their application to hedging, trading and financial engineering of structured products. The agenda will provide insight into both pricing and risking techniques for exotics. Specifically, the agenda will consider the flaws of simple pricing models in their failure to consider the implications of stochastic volatility, and the correlation between price movements and volatility, which together provide a rationalisation of the observed patterns of volatility surfaces, and will examine a number of the alternative approaches to addressing such issues. The course also provides a practical context for all instruments covered, evaluating their application in hedging and trading strategies as well as in the engineering of a variety of structured products Aimed at participants who will have previous experience with vanilla derivatives, this programme will extend understanding to the broad spectrum of the exotics marketplace and products. The training will comprise a combination of classroom based teaching combined with computer based simulations and exercises, to augment and reinforce the learning experience, and to better replicate the day to day realities of financial markets and market behaviour. Attend this 2 day advanced course and learn: Classification of exotic option types Pricing problems in valuation of exotics Alternative modelling approaches: stochastic and local volatility models Exotic FX, interest rate and equity options Risk management of exotic options; dynamic replication strategies Limitations in the use of local risk sensitivities Practical applications of exotic options: risk management, trading strategies Exotic options in structured products PLUS: Enhance your practical skills with computer-based simulations and workshop case studies on exotic option pricing, and design, modelling and pricing of structured products Who should attend? Traders and dealers Derivatives sales personnel Structurers Risk managers and risk controllers Audit managers Corporate account officers Asset managers Corporate treasury personnel
The Mechanics of Exotic Options Exotic option classification Pay-off structure Path dependency (strong and weak) Exercise timing Order Decision dependency Multivariate dependencies Motivations and applications of exotic options Vanilla options and their limitations Customised and complex pay-off structures Flexibility Risk management applications; managing corporate exposures Cost comparison (Exotics versus vanilla alternatives) When are simple or exotic option strategies optimal? Pricing and Risking Exotic Options Practical problems in modelling exotic option pay-offs Path dependency Skew risk and pricing effects Model calibration: How to adjust for smile and skew effects Vanna-Volga approach to constructing volatility surfaces Local volatility models (Dupire et al.) Advantages and shortcomings Stochastic volatility (SV) modelling Combining Local and Stochastic volatility modelling Exotic option risk characteristics - Hedging higher order moments of risk - Skew sensitivity in exotics - Discontinuous risk behaviour; limitations of using ‘Greeks’ in hedging Barrier Options Overview of types (knock-ins and knock-outs; single and double barriers) Pricing and valuation of Barrier options - Numerical (tree) methods of Barrier option pricing - Pricing double barrier options and other variants - Impact of varying barrier parameters on performance, cost - Pricing using volatility surface Hedging Barrier options Risk sensitivities and their characteristics OTM Barriers - Replication/Hedging - Change in Greeks through Time ITM Barriers - Replication/Arbitrage bounds - Change in Greeks through Time Higher order sensitivities Applications of Barrier Options - Trading and hedging applications - Rationale for barrier options – when to use and when not to use barrier options Structured barrier option strategies - Barrier structures (Forward plus) - Knock-in Cylinders - Knock-out Forwards - Knock-out Collars Applications of barrier options in structured notes - Equity Bonus notes and certificates - Twin-win certificates - Reverse convertibles Case study: Constructing and pricing Barrier option structured hedging strategies; Structured product embedded barrier options Digital (Binary) Options European and American ‘one touch’ styles Contingent Premium Options Pricing of digital options Adapting the Black-Scholes analytical approach Hedging and risk management of digital options Dynamic Delta hedging - limitations Gamma, Vega, Theta behaviour Higher order moments of risk; skew risk Replication using risk reversals Inadequacies of Black-Scholes theory in practice Applications of digital options: Trading apns – motivations for using digital options Contingent premium options ‘Range accrual’ structured notes; range accrual swaps Digital caps and floors Term sheet examples (interest rate, FX, hybrid examples) Path Dependent Options - Average Rate Options AROs (Average Rate Options) and ASOs (Average Strike Options) Mechanics of average rate options Geometric vs. Arithmetic averages Pricing of the Asian options - Continuous averaging and discrete averaging - Partial averaging: weighted and un-weighted samples - Analytical models - Numerical solutions Hedging Asian options - Risk sensitivities - Dynamic replication using Vanilla options Practical Applications of Asian Options Hedging corporate exposures with Asian options - Practical examples of the motivations and rationale for the use of Asian options - Asian Tails; Embedded Asian options – e.g. Structured equity linked bonds Case study: Pricing Asian Options; structured product applications Path Dependent Options - Lookback, Cliquet and Reverse Cliquet Options Definitions Pay-off types - Fixed and floating strike - Discrete and continuous sampling of maximum/minimum Pricing and valuation issues - Numerical (tree) methods Motivations for use – applications and examples Multi-asset Options Basket options Spread options Outperformance, ‘Best of’’ and ‘Worst of’ option styles Pricing methodologies Single factor and multi-factor approaches Impact of basket parameters (volatility, correlation) on pricing Where can we find correlation data from? Sources of implied correlation Hedging and risk management of multi-asset options Where can we find correlation data from? Sources of implied correlation Risks characteristics Cross Gamma – correlation risk Dynamic management of correlation risk Uses and applications of multi-asset options Basket options Hedging and trading spread risk Minimising cost and maximising yield enhancement with multi-asset options Structured product applications: - CMS Spread linked notes - ‘Best of’ and ‘Worst of’ structured products - Altiplanos - Multi reverse convertibles - Hybrid structured products Quanto Options Pricing quanto options Replication approach Analytical approach Pricing parameters – correlation and volatility inputs Hedging quanto derivatives Correlation and volatility risks Dynamic correlation risk management Applications of Quanto options Hedging FX translation exposure Foreign Equity/Domestic Currency Options Structured notes with quantoed pay-offs Embedded Exotic Options - Structured Products Rationale for issuers and investors Yield enhancement Capital protection Tailored investment strategies Financial engineering; creating and analysing structured debt Interest rate linked structured products Callable/Puttable bonds Range accrual structures Exotic path dependent structured notes (LIFTs, Snowballs etc.) TARNS and other path dependent structures Equity linked structures Bonus certificates Multi-asset structures Reverse convertibles Hybrids FX structured products Forward plus, knock out forwards, knock in cylinders PRDCs Range accrual structures Case study: Delegates will have the opportunity to reverse engineer a number of examples of structured products as well as creating and pricing a range of structured product types, across all main asset classes. Course summary and close