Exotic Options Trading by Frans De Weert

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Exotic Options Trading by Frans De Weert

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Forex Trading – Foreign Exchange Course

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Written by an experienced trader and consultant, Frans de Weert’s Exotic Options Trading offers a risk-focused approach to the pricing of exotic options. By giving readers the necessary tools to understand exotic options, this book serves as a manual to equip the reader with the skills to price and risk manage the most common and the most complex exotic options.

De Weert begins by explaining the risks associated with trading an exotic option before dissecting these risks through a detailed analysis of the actual economics and Greeks rather than solely stating the mathematical formulae. The book limits the use of mathematics to explain exotic options from an economic and risk perspective by means of real life examples leading to a practical interpretation of the mathematical pricing formulae.

The book covers conventional options, digital options, barrier options, cliquets, quanto options, outperformance options and variance swaps, and explains difficult concepts in simple terms, with a practical approach that gives the reader a full understanding of every aspect of each exotic option. The book also discusses structured notes with exotic options embedded in them, such as reverse convertibles, callable and puttable reverse convertibles and autocallables and shows the rationale behind these structures and their associated risks.

For each exotic option, the author makes clear why there is an investor demand; explains where the risks lie and how this affects the actual pricing; shows how best to hedge any vega or gamma exposure embedded in the exotic option and discusses the skew exposure.

By explaining the practical implications for every exotic option and how it affects the price, in addition to the necessary mathematical derivations and tools for pricing exotic options, Exotic Options Trading removes the mystique surrounding exotic options in order to give the reader a full understanding of every aspect of each exotic option, creating a useable tool for dealing with exotic options in practice.

“Although exotic options are not a new subject in finance, the coverage traditionally afforded by many texts is either too high level or overly mathematical. De Weert’s exceptional text fills this gap superbly. It is a rigorous treatment of a number of exotic structures and includes numerous examples to clearly illustrate the principles. What makes this book unique is that it manages to strike a fantastic balance between the theory and actual trading practice. Although it may be something of an overused phrase to describe this book as compulsory reading, I can assure any reader they will not be disappointed.”

—Neil Schofield, Training Consultant and author of Commodity Derivatives: Markets and Applications

“Exotic Options Trading does an excellent job in providing a succinct and exhaustive overview of exotic options. The real edge of this book is that it explains exotic options from a risk and economical perspective and provides a clear link to the actual profit and pricing formulae. In short, a must read for anyone who wants to get deep insights into exotic options and start trading them profitably.”

—Arturo Bignardi

Table of Contents

Contents

Preface

Acknowledgements

1 Introduction

2 Conventional Options, Forwards and Greeks

2.1 Call and Put Options and Forwards

2.2 Pricing Calls and Puts

2.3 Implied Volatility

2.4 Determining the Strike of the Forward

2.5 Pricing of Stock Options Including Dividends

2.6 Pricing Options in Terms of the Forward

2.7 Put-Call Parity

2.8 Delta

2.9 Dynamic Hedging

2.10 Gamma

2.11 Vega

2.12 Theta

2.13 Higher Order Derivatives Like Vanna and Vomma

2.14 Option’s Interest Rate Exposure in Terms of Financing the Delta Hedge

3 Profit on Gamma and Relation to Theta

4 Delta Cash and Gamma Cash

4.1 Example Delta and Gamma Cash

5 Skew

5.1 Reasons for Higher Realised Volatility in Falling Markets

5.2 Skew Through Time: ‘The Term Structure of Skew’

5.3 Skew and Its Effect on Delta

5.4 Skew in FX versus Skew in Equity: ‘Smile versus Downward Sloping’

5.5 Pricing Options Using the Skew Curve

6 Simple Option Strategies

6.1 Call Spread

6.2 Put Spread

6.3 Collar

6.4 Straddle

6.5 Strangle

7 Monte Carlo Processes

7.1 Monte Carlo Process Principle

7.2 Binomial Tree versus Monte Carlo Process

7.3 Binomial Tree Example

7.4 The Workings of the Monte Carlo Process

8 Chooser Option

8.1 Pricing Example Simple Chooser Option

8.2 Rationale Behind Chooser Option Strategies

9 Digital Options

9.1 Choosing the Strikes

9.2 The Call Spread as Proxy for the Digital

9.3 Width of the Call Spread versus Gearing

10 Barrier Options

10.1 Down-and-In Put Option

10.2 Delta Change over the Barrier for a Down-and-In Put Option

10.3 Factors Influencing the Magnitude of the Barrier Shift

10.4 Delta Impact of a Barrier Shift

10.5 Situations to Buy Shares in Case of a Barrier Breach of a Long Down-and-In Put

10.6 Up-and-Out Call

10.7 Up-and-Out Call Option with Rebate

10.8 Vega Exposure Up-and-Out Call Option

10.9 Up-and-Out Put

10.10 Barrier Parity

10.11 Barrier at Maturity Only

10.12 Skew and Barrier Options

10.13 Double Barriers

11 Forward Starting Options

11.1 Forward Starting and Regular Option Compared

11.2 Hedging the Skew Delta of the Forward Start Option

11.3 The Forward Start Option and the Skew Term Structure

11.4 Analytically Short Skew but Dynamically No Skew Exposure

11.5 Forward Starting Greeks

12 Ladder Options

12.1 Example Ladder Option

12.2 Pricing the Ladder Option

13 Lookback Options

13.1 Pricing and Gamma Profile of Fixed Strike Lookback Options

13.2 Pricing and Risk of a Floating Strike Lookback Option

14 Cliquets

14.1 The Ratchet Option

14.2 Risks of a Ratchet Option

15 Reverse Convertibles

15.1 Example Knock-in Reverse Convertible

15.2 Pricing the Knock-in Reverse Convertible

15.3 Market Conditions for Most Attractive Coupon

15.4 Hedging the Reverse Convertible

16 Autocallables

16.1 Example Autocallable Reverse Convertible

16.2 Pricing the Autocallable

16.3 Autocallable Pricing without Conditional Coupon

16.4 Interest/Equity Correlation within the Autocallable

17 Callable and Puttable Reverse Convertible

17.1 Pricing the Callable Reverse Convertible

17.2 Pricing the Puttable Reverse Convertible

18 Asian Options

18.1 Pricing the Geometric Asian Out Option

18.2 Pricing the Arithmetic Asian Out Option

18.3 Delta Hedging the Arithmetic Asian Out Option

18.4 Vega, Gamma and Theta of the Arithmetic Asian Out Option

18.5 Delta Hedging the Asian in Option

18.6 Asian in Forward

18.7 Pricing the Asian in Forward

18.8 Asian in Forward with Optional Early Termination

19 Quanto Options

19.1 Pricing and Correlation Risk of the Option

19.2 Hedging FX Exposure on the Quanto Option

20 Composite Options

20.1 An Example of the Composite Option

20.2 Hedging FX Exposure on the Composite Option

21 Outperformance Options

21.1 Example of an Outperformance Option

21.2 Outperformance Option Described as a Composite Option

21.3 Correlation Position of the Outperformance Option

21.4 Hedging of Outperformance Options

22 Best of andWorst of Options

22.1 Correlation Risk for the Best of Option

22.2 Correlation Risk for the Worst of Option

22.3 Hybrids

23 Variance Swaps

23.1 Variance Swap Payoff Example

23.2 Replicating the Variance Swap with Options

23.3 Greeks of the Variance Swap

23.4 Mystery of Gamma Without Delta

23.5 Realised Variance Volatility versus Standard Deviation

23.6 Event Risk of a Variance Swap versus a Single Option

23.7 Relation Between Vega Exposure and Variance Notional

23.8 Skew Delta

23.9 Vega Convexity

24 Dispersion

24.1 Pricing Basket Options

24.2 Basket Volatility Derived From Its Constituents

24.3 Trading Dispersion

24.4 Quoting Dispersion in Terms of Correlation

24.5 Dispersion Means Trading a Combination of Volatility and Correlation

24.6 Ratio’d Vega Dispersion

24.7 Skew Delta Position Embedded in Dispersion

25 Engineering Financial Structures

25.1 Capital Guaranteed Products

25.2 Attractive Market Conditions for Capital Guaranteed Products

25.3 Exposure Products for the Cautious Equity Investor

25.4 Leveraged Products for the Risk Seeking Investor

Appendix A Variance of a Composite Option and Outperformance Option

Appendix B Replicating the Variance Swap

References

Index

Author Information

About the author

FRANS DE WEERT is mathematician by training. After obtaining his masters in Mathematics, specializing in probability theory and financial mathematics at the University of Utrecht, he went on to do a research degree, M.Phil, in probability theory at the University of Manchester.

After his academic career he started working as a trader for Barclays Capital in London. In this role he gained experience in trading many different derivative products on European and American equities. After two and half years in London, he moved to New York to start trading derivatives on both Latin American as well as US underlyings.

Frans currently works as a strategy consultant at Booz Allen Hamilton and lives in Amsterdam, The Netherlands.