Chapter 20
Exotic FX Derivatives Product Classification
Exotic products are typically split into different generations, indicating how long the product has been traded in the market. When reviewing the exotic product classification it is important to understand that risk management does not get more complicated for higher-generation options. In fact, the opposite is often true as features like averages, accruing notionals, or targets can reduce risk management complexity. In general, exotic products which are conceptually simple are often harder to risk manage while exotic products which are conceptually more involved are often easier to risk manage.
The following list of exotic FX derivative product types is by no means exhaustive; it primarily aims to introduce the main exotic option types. Exotic features can be combined and extended in many different ways. Over time, different products and structures come in and out of fashion, plus new structures are developed by innovative trading and structuring desks to meet client requirements.
First-Generation Exotics
First-generation exotic products are the fundamental building blocks of exotic risk. The two primary exotic features are European barriers and American barriers. European digitals and touch options are the simplest exotic contracts, followed by European and American barrier options.
European Digital Options
European digital options payout cash if spot is above (CCY1 digital call) or below (CCY1 digital put) the digital level at maturity. If it happens, the cash payment actually occurs on the delivery date.
European digital example: EUR/USD 1yr 1.3000 EUR digital call in EUR1m payout. Digital options are quoted as a % of the payout, so if the offer is 25.0 EUR%, the contract will cost EUR250k. Like vanillas, it is most common to trade the out-of-the-money side so European digital prices will rarely be above 50%.
European digital options are known by various other names, including binary options, cash-or-nothing options, or digital bets. They are covered in Chapter 21.
Touch Options
Touch options, also called rebates or American digitals, generate a cash payout at maturity if spot ever touched (one-touch) or never touched (no-touch) specified barrier levels. The barriers within touch options are called American or continuous because they are active throughout the life of the option.
If the touch option has a single barrier, it is called a one-touch (OT) or a no-touch (NT). If it has two barriers, it is called a double-one-touch (DOT) or a double-no-touch (DNT), plus double-no-touch options are also known as ranges. Within double barrier touch options, at inception, one barrier must be above spot and one barrier must be below.
Standard touch options pay out on the delivery date. There are also instant touch options, which instead pay out two business days (value spot) after the barrier is hit. The market convention is to trade single barrier touches as one-touch options with payout at maturity and two barrier touches as double-no-touch options.
One-touch example: EUR/USD 1yr 1.3000 one-touch with USD1m payout. Like European digitals, touch options are quoted as a % of the payout, so if the price is 10.5 USD%, the contract will cost USD105k.
Touch options are covered in Chapter 23.
Barrier Options
Barrier options pay off like a vanilla option at maturity. Additionally, they have barriers that can knock the option out (i.e., expire it) or knock the option in (i.e., enable the payoff). There are two main types of barrier: European and American.
European Barrier Options
European barriers are only applicable at the option maturity. European barrier levels must therefore be positioned in-the-money versus the payoff; otherwise they have no impact.
European knock-out example: EUR/USD 1yr 1.3000 EUR call/USD put European knock-out (EKO) 1.4500. If spot at maturity is below 1.4500, the payoff of this option will be the same as a EUR call/USD put vanilla option with the same strike. However, if spot at maturity is above 1.4500, the EKO will have no payoff because spot is through the knock-out barrier. This is shown in Exhibit 20.1.
Exhibit 20.1 European knock-out call option payoff at maturity
European knock-in example: EUR/USD 1yr 1.3000 EUR call/USD put European knock-in (EKI) 1.4500. If spot at maturity is below 1.4500, the option will have no payoff because spot is not through the knock-in barrier. However, if spot at maturity is above 1.4500, the payoff of the option will be the same as a EUR call/USD put vanilla option with the same strike. This is shown in Exhibit 20.2.
Exhibit 20.2 European knock-in call option payoff at maturity
European barrier options are covered in Chapter 22.
American Barrier Options
American knock-out and knock-in barriers exist continuously throughout the life of the option. If spot ever trades through the barrier level prior to expiry, the structure either knocks in (comes alive) or knocks out (expires). In the standard variations of the product, barriers within the structure are either all knock-out or all knock-in.
To clarify what is meant by “ever” in the previous paragraph: In liquid G10 currency pairs, for the barrier to have triggered, spot must usually have traded through the barrier level between Monday 9 a.m. Wellington time (sometimes called “market open”) and Friday 5 p.m. New York time (sometimes called “market close”) in “market size,” generally around USD5m. In emerging-market currency pairs, the spot market usually has to be officially open for a barrier knock to occur. The exact details of what constitutes a barrier knock are described within the confirmation (“confo”) documents, plus for each option there is a barrier determining agent—one of the option counterparties who makes a fair final decision on whether there has been a barrier knock if a disagreement occurs.
The relative positioning of the strike and barrier within the option determines what an American barrier option is called. If the option has a single American barrier positioned out-of-the-money versus the payoff, the option is a regular knock-out or regular knock-in. Often the “regular” is dropped and these contracts are simply called knock-out (KO) or knock-in (KI) options.
Knock-out example: EUR/USD 1yr 1.3000 EUR call/USD put knock-out 1.2000. This option will pay off like a 1.3000 EUR call/USD put vanilla option at maturity unless spot ever trades through (below) 1.2000 during the life of the option, in which case there will be no payoff at maturity. This is shown in Exhibit 20.3.
Exhibit 20.3 Knock-out option structure
If the option structure has a single barrier positioned in-the-money versus the payoff, the option is a reverse knock-out (RKO) or reverse knock-in (RKI).
Reverse knock-out example: EUR/USD 1yr 1.3000 EUR call/USD put reverse knock-out 1.4000. This option will pay off like a 1.3000 EUR call/USD put vanilla option at maturity unless spot ever trades through (above) 1.4000 during the life of the option, in which case there will be no payoff at maturity. This is shown in Exhibit 20.4.
Exhibit 20.4 Reverse knock-out option structure
If an option structure has two American barriers, one either side of the inception spot level, it is a double knock-out (DKO) or double knock-in (DKI).
Double knock-out example: EUR/USD 1yr 1.3000 EUR call/USD put double knock-out 1.2000/1.4000. This option will pay off like a 1.3000 EUR call/USD put vanilla option at maturity unless spot ever trades through (below) 1.2000 or (above) 1.4000 during the life of the option, in which case there will be no payoff at maturity. This is shown in Exhibit 20.5.
Exhibit 20.5 Double knock-out option structure
Payoff, valuation, and exposure charts for options with American barriers assume that barriers have not knocked. However, once spot goes through an American barrier level, exposures change. For a knock-out American barrier, all exposures disappear when the barrier hits, whereas for a knock-in American barrier, the exposures become that of a standard vanilla option.
Different types of American barrier are shown in Chapter 24.
In-the-Money Barrier Options
If a single American barrier is positioned in-the-money versus the payoff and the inception spot is even further in-the-money, this is a special case called an in-the-money (ITM) barrier option.
In-the-money knock-out example: EUR/USD 1yr 1.1000 EUR call/USD put ITM knock-out 1.2000 with spot at 1.3000. This option will pay off like a 1.1000 EUR call/USD put vanilla option at maturity unless spot ever trades through (below) 1.2000 during the life of the option, in which case there will be no payoff at maturity. This is shown in Exhibit 20.6.
Exhibit 20.6 ITM knock-out option structure
If the strike and barrier are at the same level, the option is called a strike-out (for a knock-out barrier) or strike-in (for a knock-in barrier). The trading risks on ITM barrier options are different from regular American barriers. In the ITM knock-out case spot can never go through the strike and hence the strike produces no optionality.
Transatlantic Barrier Options
Transatlantic barrier options have a vanilla payoff at maturity plus one American barrier and one European barrier (hence the name). Both barriers can be separately either knock-out or knock-in but the most common configuration has a knock-in European barrier and a knock-out American barrier.
Transatlantic example: EUR/USD 1yr 1.3000 EUR call/USD put European knock-in 1.4500/American knock-out 1.2500. This option will pay off like a 1.3000 EUR call/USD put European knock-in 1.4500 at maturity unless spot ever trades through (below) 1.2500 during the life of the option, in which case there will be no payoff at maturity. This is shown in Exhibit 20.7.
Exhibit 20.7 Transatlantic option structure
Within the transatlantic option, the European barrier is always positioned in-the-money versus the payoff (otherwise it has no impact) and the American barrier is usually positioned out-of-the-money versus the payoff.
Knock-in/Knock-out Barrier Options
Knock-in/Knock-out (KIKO) barrier options have a vanilla payoff at maturity plus two American barriers: One barrier is knock-in and the other is knock-out. The subtlety with this product comes from the fact that there are two possible variations:
- Knock-out until expiry. If the knock-in barrier hits first, the option will still knock out if the knock-out barrier level trades later.
- Knock-out until knock in. If the knock-in barrier hits first, the option cannot then be knocked out and therefore the option has a guaranteed payoff at maturity.
Discrete Barrier Options
Discrete barrier options are monitored against a specified (usually daily) fix rather than being continuously monitored against the spot market.
Discrete barrier example: EUR/USD 1yr 1.3000 EUR call/USD put knock-out at 1.4500 on ECB37 fix. The ECB37 fix is sampled daily from the spot market at around 2.15 p.m. Central European time (CET) and then published to a website shortly after.
Discrete barrier monitoring creates additional risk management challenges to standard American or European barriers.
Discrete barriers are covered in Chapter 26.
American Vanilla Options
American vanilla options are identical to standard European vanilla options except that American vanilla options can be exercised by the option buyer at any time prior to expiry where European vanilla options can only be exercised by the option buyer at expiry.
This early exercise feature is mainly applicable to vanilla options. A client once asked for a price in a reverse knock-out with American exercise: Definitely not a standard product.
American vanilla options are covered in Chapter 27.
Quanto Options
Quanto options have nonstandard payoff currencies. As seen in Part I, the natural vanilla payoff case is CCY1 notional and CCY2 payout. If this becomes a CCY1 notional and CCY1 payout, with conversion from CCY2 payout to CCY1 payout using the strike rather than the spot at expiry, this is a self-quanto option, covered in Chapter 27. Alternatively, if payout is in CCY3 (i.e., neither CCY1 nor CCY2), this is a third currency quanto option, covered in Chapter 30.
Second-Generation Exotics
Second-generation exotics add additional features to forwards, vanilla options, or first-generation exotic products. For example, window barrier options are extensions of American barrier options while accrual, target redemption, and Asian options each extend standard forward or European vanilla payoffs.
Window Barrier Options
Window barrier options exist for some (but not all) of the life of the option. If barrier observation starts at the option inception and goes until some date prior to expiry, the option is a front window barrier option. If barrier observation starts at some date after horizon and ends at the option expiry, the option is a rear window barrier option. Like American barrier options there are up barrier, down barrier, knock-in, knock-out, and double barrier variations.
Window barrier options are covered in Chapter 26.
Accrual Options
Within accrual options, the option notional is not fixed but rather it accrues (builds up) over the life of the option depending on how spot moves. For example, it could be that each time there is a daily fix where spot lies between 1.2500 and 1.3500 the option notional increases by USD100k, whereas if spot fixes below 1.2500 or above 1.3500 the option notional will not increase.
The most commonly traded option structure involving an accrual feature is the accrual forward. At maturity, the client buys or sells the accrued notional at the strike.
Accrual options are covered in Chapter 28.
Target Redemption Options
Within target redemption options, the payoff is generally a strip of forwards or leveraged forwards that knock out if some target is reached. This target can be specified in different ways, for example, cumulative client profit or the number of expiry dates at which the client has profited.
The most common option structure involving a target redemption feature is the target redemption forward (TARF). At each fixing, the client transacts a fixed notional, providing the target has not been reached.
Target redemption options are covered in Chapter 28.
Asian Options
Asian options are also known as average rate options. Some aspect of the Asian option payoff depends on an average calculated from spot fixings. There are three common variations:
- Average rate option: spot at maturity is replaced with an average of spot fixings.
- Average strike option: the option strike is replaced with an average of spot fixings.
- Double average rate option: both spot at maturity and the strike are replaced by averages of spot fixes taken over different periods during the life of the option.
Asian options are covered in Chapter 29.
Compound Options
Compound options are an option on an option. The owner of the compound option has the opportunity at a first expiry date to buy or sell a specified vanilla option to a second expiry date for a fixed premium. This product is covered in Chapter 31.
Forward Start Options
The contract details (e.g., strike and barrier levels) on forward start options are determined from a spot fix at a specified date in the future. For example, after three months a spot fix is used to set the strike of a call option expiring three months later. This product is covered in Chapter 30.
Third-Generation Exotics
Third-generation exotics cover multi-asset products, volatility products, and correlation products. These options are often risk managed in separate trading books due to their complexity.
Basket Options
Basket options have a payoff based on a basket spot which is calculated by averaging spot changes across the currency pairs in the basket. At maturity the payoff is a function of the basket spot and a basket strike. This product is covered in Chapter 30.
Best-of/Worst-of Options
Best-of (BO) and Worst-of (WO) options pay out either the best (maximum) or worst (minimum) payoff resulting from vanilla options in multiple currency pairs to the same expiry date. The payoff is highly dependent on the correlation between currency pairs. This product is covered in Chapter 30.
Dual Digital Options
Dual digital options have two European digital payoffs in different currency pairs to the same expiry date. If both digitals are in-the-money at maturity, the option generates a cash payout. This product is covered in Chapter 30.
Volatility (Vol) and Variance (Var) Swaps
Volatility swaps pay out based on realized spot volatility compared to a “strike” expressed in volatility terms. Variance swaps pay out based on realized spot variance compared to a “strike” expressed in variance terms. This product is covered in Chapter 31.
Correlation Swaps
Correlation swaps pay out based on realized spot correlation between two currency pairs compared to a “strike” expressed in correlation terms.
Forward Volatility Agreements (FVA)
Forward volatility agreements pay out based on the future level of implied volatility. For example, a 3mth in 3mth FVA is a trade on the forward ATM implied volatility between the 3mth expiry date and the 6mth expiry date. This product is covered in Chapter 31.