(Almost) Everything You Wanted To Know About FX Volatility Smile (Part II) —Exotic Options, Vol Dynamic, and Everything in Between.

Underneath The Surface

We can distinguish between five main types of exotic options:

  1. Barrier Options -these options are vanilla options with contingency (which makes them highly path-dependent). Knock-Out (KO) option will act as a plain vanilla option as long as the KO level is not touched, while Knock-In (KI) option ONLY becomes a vanilla option if the KI level is touched. There are further modifications we can apply (like how frequently the barrier is monitored), but the basics are the same.
  2. Payout Options (cash-or-nothing) — these options pay a predefined/fixed payout contingent on the condition (trigger) being met. Among these options, we can find One-Touch (OT) / No-Touch (NT), and digital options. The main difference between digital options and touch options is that digital options are European style options (i.e., the trigger is observed once, at expiry), while touch options are American style options (continuous monitoring of the trigger level). Like 1st-generation exotics, we can add conditions to increase the leverage (cheapen the option price). For example, we can add triggers (so instead of a No-Touch, we can trade Double No-Touch, which increases the chances of the option being knocked out)
  3. Strikeless volatility contracts — unlike vanilla-type options that have fixed strikes, strikeless volatility products allow investors to gain the purest exposure to realized/implied volatility. Products like Volatility Swaps and Correlation Swaps have constant gamma/vega exposure and pay/receive the difference between realized vol/correlation and a fixed vol/corr strike. Among these products, we can also find FVA (forward-vol agreement), which allows investors to gain exposure to the volatility term structure and forward volatility in a strikeless manner (unlike calendar spread).
  4. Forward Structures — Forward structures are essentially strips of forwards with embedded optionality that allow the holder of the structure to pay/receive a stream of cashflows at a predefined rate. Used mostly by corporates to hedge payables/receivables, these products usually gain popularity when uncertainty grows in the market (or in periods of steep appreciation/depreciation of the local currency). As they are used to hedge future cashflows (usually with long duration), these products are traded further out on the term structure.
  5. Hybrid/Correlation products — The correlation-based exotics are probably the poster child of financial innovation and quantitative finance. These products, which include structures like basket options (and “best-of”/”worst-of” baskets), dual currency binary options, and cross-asset structures, try to benefit from mispriced correlation to provide leverage to these products. It goes without saying that modeling them is highly difficult and requires “rocket-science” level quantitative models.
Vega Profile of RKO Call and 25-delta Risk Reversal
Vega Profile of Double No-Touch and a Butterfly Spread

A Trip Down Exotics Lane

Breaking The Barriers

  1. as spot moves towards the KO barrier dealers get longer vega (and 2nd order vega derivatives like Vanna and Volga), so they, in theory, should sell the inherit vega coming from these options. Also, dealers get longer gamma, so as the spot moves up/down they need to sell/buy delta (or take profit on their delta)
  2. Once the barrier hits the option ceases to exist, so all the greeks that were traded against that option need to be unwound, which is why we often see a “wash” move at an area with a large cluster of barriers (usually in tandem with increasing implied vol/RR.

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Harel Jacobson

Harel Jacobson

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Global Volatility Trading. Python addict. Bloomberg Junkie. Amateur Boxer and boxing coach (RSB cert.)!No investment advice!