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Exotic Options Trading by Frans De Weert

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Description

Frans de Weert’s Exotic Options Trading, written by a seasoned trader and consultant, presents a risk-focused method for pricing exotic options. This book acts as a guidebook to provide the reader with the abilities to price and risk manage the most frequent and most complicated exotic options by providing readers with the required tools to comprehend exotic options.

De Weert first discusses the dangers of trading exotic options before analyzing these dangers in depth using actual economics and Greeks rather than just reciting mathematical formulas. Through the use of real-world examples and a practical interpretation of the mathematical pricing formulae, the book restricts the use of mathematics to explain exotic alternatives from an economic and risk viewpoint.

The book discusses conventional options, digital options, barrier options, cliquets, quanto options, outperformance options, and variance swaps. It breaks down complex ideas into simple language and takes a hands-on approach to help the reader fully comprehend each exotic option’s nuances. The book also covers structured notes with integrated exotic options, such reverse convertibles, callable and puttable reverse convertibles, and autocallables, and explains the advantages and disadvantages of each structure.

The author explains why there is investor demand for each exotic option, where the risks are and how they effect price, how to appropriately hedge any vega or gamma exposure inherent in the exotic option, and talks about skew exposure.

Exotic Options Trading dispels the mystique surrounding exotic options to give the reader a complete understanding of every exotic option and creates a useful tool for dealing with exotic options in practice by outlining 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.

“Even though exotic options are not a new topic in finance, many texts have a history of providing information that is either excessively advanced or overly mathematical. This void is admirably filled by De Weert’s outstanding writing. It is a thorough examination of several unusual structures and contains lots of examples to make the ideas crystal obvious. This book stands out because it achieves a superb balance between trading theory and practical practice. Although calling this book required reading may be a bit of an overstatement, I can tell readers that they won’t be let down.

—Neil Schofield, author of Commodity Derivatives: Markets and Applications and a training consultant.

The concise and thorough introduction of exotic options provided by Exotic Options Trading is outstanding. The major advantage of this book is that it makes a clear connection between the actual profit and pricing formulae while explaining exotic options from a risk and economic standpoint. A must-read for anyone who wants to gain a thorough understanding of exotic options and begin trading them profitably, in other words.

Arthur Bignardi

Summary of Contents

Contents

Preface

Acknowledgements

1 Initialization

Standard Options, Forwards, and Greeks 2

2.1 Forwards with Call and Put Options

2.2 Call and Put Pricing

Implied Volatility (2.3)

2.4 Determining the Forward Strike

2.5 Stock Option Pricing Including Dividends

2.6 Options for Pricing the Forward

Put-Call Parity of 2.7

2.8 Delta

Dynamic Hedging

2.10 Gamma

2.11 Vega

2.12 Theta

2.13 Higher Order Derivatives, Such as Vomma and Vanna

2.14 The Delta Hedge’s Interest Rate Exposure under the Option’s Financing

3 Gamma Profit and Its Relation to Theta

4 Gamma and Delta Cash

4.1 Delta and Gamma Cash Example

5 Skew

5.1 Factors Contributing to Higher Actual Volatility in Falling Markets

5.2 The Term Structure of Skew: Skew Through Time

Skew and Delta: Their Relationship

5.4 “Smile vs Downward Sloping”: Skew in FX versus Skew in Equity

5.5 Skew Curve Pricing Alternatives

6 Basic Option Techniques

Call Spread, 6.

Put Spread, 6.

6.3 Neck

6.4 Cross over

Strangle 6.5

Seven Monte Carlo Methods

7.1 Principle of the Monte Carlo Process

7.2 Monte Carlo Process vs. Binomial Tree

7.3 Example of a Binomial Tree

7.4 The Monte Carlo Process in Action

8 Chooser’s Choice

8.1 Simple Chooser Option Pricing Example

8.2 The Justification for Chooser Option Strategies

Nine digital choices

9.1 Picking your strikes

9.2 The Call Spread as a Digital Replacer

9.3 Call spread width versus gearing

10 options for barriers

Option to Put Down and In

10.2 Delta Change over the Barrier for a Put Option with a Downward Movement

10.3 Elements That Affect the Size of the Barrier Shift

10.4 Impact of a Barrier Shift in the Delta

10.5 When to Buy Shares in the Event of a Long Down-and-In Put’s Barrier Breach

10.6 Call to Exit

Option for Up-and-Out Calls with Rebate 10.7

Option 10.8 Vega Exposure Up-and-Out

Up-and-Out Put: 10.9

Barrier Parity 10.10

10.11 Maturity-Only Barrier

10.12 Options for Skew and Barrier

Double Barriers 10.13

11 Options for Forward Starting

11.1 Comparison of the Forward Starting and Regular Option

11.2 Hedging the Forward Start Option’s Skew Delta

11.3 The Skew Term Structure and the Forward Start Option

11.4 Dynamically No Skew Exposure yet Analytically Short Skew

11.5 Greek Forward Starting

Options for 12 Ladders

Example Ladder Option 12.1

12.2 Ladder Option Pricing

13 Options for Rewinding

13.1 Fixed Strike Lookback Option Prices and Gamma Profiles

Floating strike lookback option pricing and risk

14 cleats

The Ratchet Option 14.

14.2 Ratchet Option Risks

Reverse convertibles: 15

Example of a Reverse Convertible Knock-in

15.2 The Knock-in Reverse Convertible’s price

15.3 Market Situation for the Best Coupon

15.4 The Reverse Convertible Hedged

16 automatic calls

16.1 Illustration of a Reverse Autocallable Convertible

16.2 The Autocallable’s Price

16.3 No conditional coupon autocallable pricing

16.4 Correlation of Interest and Equity for the Autocallable

17 Reverse Convertible Callable and Puttable

17.1 The Callable Reverse Convertible’s Price

17.2 The Puttable Reverse Convertible’s Price

18 Asian Alternatives

18.1 The Geometric Asian Out Option’s Price

18.2 The Arithmetic Asian Out Pricing Option

18.3 The Arithmetic Asian Out Option for Delta Hedging

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

18.5 Delta The Asian In Option Hedging

Asian in Forward 18.6

18.7 Estimating the Asian in Advance

With a potential early termination option, 18.8 Asian in Forward

Quanto Options 19

19.1 The Option’s Pricing and Correlation Risk

19.2 Quanto Option Hedging of Foreign Exchange Exposure

twenty composite choices

An Illustration of the Composite Option 20.1

20.2 The Composite Option’s FX Exposure Hedging

21 Options for Outperformance

21.1 An illustration of an outperformance choice

21.2 A composite option that is described as an outperformance option

21.3 Outperformance Option’s Correlation Position

21.4 Hedging of Options for Outperformance

22 Options: The Best and Worst

22.1 The Best Option’s Correlation Risk

22.2 The Worst Option’s Correlation Risk

Hybrids, 22.3

Variance Swaps 23,

Example of Variance Swap Payoff in 23.1

23.2 Using Options to Replicate the Variance Swap

Greeks of the Variance Swap, section 23

23.4 Gamma Without Delta Mysteries

23.5 Volatility vs Realized Variance against Standard Deviation

Event Risk of a Variance Swap as Compared to a Single Option, 23.6

23.7 Vega Exposure and Variance Notional Relationship

Skew Delta: 23.8

Vega Convexity: 23.9

Dispersion 24

Options for pricing baskets, 24.1

24.2 Basket Volatility Is Determined By Its Components

Trading Dispersion, 24.3

24.4 Correlation-Based Quoting Dispersion

24.5 Trading with Dispersion Involves Combining Volatility and Correlation

Ratio’d Vega Dispersion: 24.6

Skew Delta Position in Dispersion at 24.7

25 Financial Engineering Structures

Capital-guaranteed products (25.1)

25.2 Favorable Market Conditions for Products with Capital Guarantees

Exposure Products for the Careful Equity Investor, Section 25.3

Leveraged Products for the Risk-Taking Investor, Section 25.4

Appendix A: Composite Option Variation and Outperformance Option

Reproducing the Variance Swap in Appendix B

References

Index

Details about the Author

Who the author is

By profession, FRANS DE WEERT is a mathematician. At the University of Utrecht, where he earned his master’s degree in mathematics with a focus on probability theory and financial mathematics, he continued on to complete an M.Phil. in probability theory as a research degree.

He began working as a trader for Barclays Capital in London after finishing his academic career. In this capacity, he had expertise trading a wide range of derivative instruments on American and European stocks. He traveled to New York to begin trading derivatives on both US and Latin American underlyings after spending two and a half years in London.

Frans presently resides in Amsterdam, the Netherlands, and works as a strategy consultant for Booz Allen Hamilton.

Salepage : Exotic Options Trading by Frans De Weert