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Exotic options have taken the market by storm. With the advent and explosive growth of the derivatives market in the last decade, there has been an enormous increase in the willingness to assess risk and create structures which cater to users' preferences. To many prospective users of exotic options, the features at first glance may seem gimmicky, if not whimsical, and are often greeted suspiciously particularly when it comes to assessing their value. The experienced, sophisticated user can easily and eagerly embrace such products since they provide the opportunity to tailor the risk/return profile with precision.
The benefits of this new class of derivative product can be illustrated by examining the difference between a forward and a conventional option. While a forward locks in a future rate or price, the user is prevented from enjoying any favourable movements. An option, on the other hand, gives the buyer the opportunity to benefit from favourable movements while being protected from adverse movements--but at a price.
As an alternative to buying the option and paying a premium, the user can replicate the pay-off profile of the option by using forwards. This can be accomplished by creating an initial position equal to half the desired amount of an at-the-money option. As the price moves favourably, the position is increased, and decreased as it moves unfavourably. This dynamic approach to creating a position by "buying high" and "selling low" results in an expected incremental cost equal to the option premium.
Not every option user has the technology, time, skill, or patience to monitor and manage a position with such diligence. Instead, the user pays a premium to an option provider to assume the risk and perform the necessary management operations.
Exotic options can provide similar benefits by adding features that permit the user to manage only those specific risks which are of interest. For instance, the revenue stream of a gold mining company is exposed to the price of gold. If gold prices rise, the firm will be able to absorb increases in interest expense occasioned by higher floating rates. To the extent that gold prices fall and interest rates rise, earnings will suffer accordingly. The company could purchase a conventional Libor cap to protect against rising interest rates, but...