What are Exotic Options?
As the word represents, Exotic options are the options that are used rarely and are highly customized. Exotic options are the opposite of plain vanilla options generally traded on exchanges in fairly liquid markets. Exotic options are traded in the OTC market and meet typically a specific firm's need for Hedging that plain vanilla options cannot meet. The main objective behind building exotic options is to provide a unique and customized hedge for a firm's needs.
Examples of Exotic Options:
There are several classic examples of Exotic Options. The gap option is an example of an Exotic option in which the concept of trigger price is used that gives a gap in the cash flows.
Why is it essential to know Exotic Options:
Exotic options can:
- provide more efficient Hedging than plain vanilla options
- reflect a firm’s view on interest rates, exchange rates, and commodity prices
- be used for tax or regulatory purposes