Exotic Options Trading Book

Preface     xi
Acknowledgements     xiii
Introduction     1
Conventional Options, Forwards and Greeks     3
Call and Put Options and Forwards     3
Pricing Calls and Puts     6
Implied Volatility     8
Determining the Strike of the Forward     8
Pricing of Stock Options Including Dividends     9
Pricing Options in Terms of the Forward     10
Put-Call Parity     11
Delta     12
Dynamic Hedging     14
Gamma     14
Vega     16
Theta     18
Higher Order Derivatives Like Vanna and Vomma     19
Options' Interest Rate Exposure in Terms of Financing the Delta Hedge     21
Profit on Gamma and Relation to Theta     23
Delta Cash and Gamma Cash     25
Example: Delta and Gamma Cash     26
Skew     27
Reasons for Higher Realised Volatility in Falling Markets     27
Skew Through Time: 'The Term Structure of Skew'     28
Skew and its Effect on Delta     29
Skew in FX versus Skew in Equity: 'Smile versus Downward Sloping'     32
Pricing Options Using the Skew Curve     34
Simple Option Strategies     35
Call Spread     35
Put Spread     37
Collar     39
Straddle     40
Strangle     42
Monte Carlo Processes     45
Monte Carlo Process Principle     45
Binomial Tree versus Monte Carlo Process     46
Binomial Tree Example     46
The Workings of the Monte Carlo Process     48
Chooser Option     49
Pricing Example: Simple Chooser Option     49
Rationale Behind Chooser Option Strategies     51
Digital Options     53
Choosing the Strikes     55
The Call Spread as Proxy for the Digital     55
Width of the Call Spread versus Gearing     55
Barrier Options     57
Down-and-In Put Option     58
Delta Change over the Barrier for a Down-and-In Put Option     58
Factors Influencing the Magnitude of the Barrier Shift     60
Delta Impact of a Barrier Shift     63
Situations to Buy Shares in Case of a Barrier Breach of a Long Down-and-In Put     63
Up-and-Out Call     63
Up-and-Out Call Option with Rebate     64
Vega Exposure Up-and-Out Call Option      64
Up-and-Out Put     65
Barrier Parity     65
Barrier at Maturity Only     65
Skew and Barrier Options     66
Double Barriers     68
Forward Starting Options     71
Forward Starting and Regular Options Compared     71
Hedging the Skew Delta of the Forward Start Option     72
The Forward Start Option and the Skew Term Structure     73
Analytically Short Skew but Dynamically No Skew Exposure     74
Forward Starting Greeks     75
Ladder Options     77
Example: Ladder Option     77
Pricing the Ladder Option     78
Lookback Options     79
Pricing and Gamma Profile of Fixed Strike Lookback Options     79
Pricing and Risk of a Floating Strike Lookback Option     80
Cliquets     83
The Ratchet Option     83
Risks of a Ratchet Option     85
Reverse Convertibles     87
Example: Knock-in Reverse Convertible     87
Pricing the Knock-in Reverse Convertible     89
Market Conditions for Most Attractive Coupon     89
Hedging the Reverse Convertible     90
Autocallables      93
Example: Autocallable Reverse Convertible     93
Pricing the Autocallable     95
Autocallable Pricing without Conditional Coupon     97
Interest/Equity Correlation within the Autocallable     98
Callable and Puttable Reverse Convertibles     99
Pricing the Callable Reverse Convertible     99
Pricing the Puttable Reverse Convertible     102
Asian Options     105
Pricing the Geometric Asian Out Option     105
Pricing the Arithmetic Asian Out Option     107
Delta Hedging the Arithmetic Asian Out Option     109
Vega, Gamma and Theta of the Arithmetic Asian Out Option     110
Delta Hedging the Asian in Option     110
Asian in Forward     112
Pricing the Asian in Forward     114
Asian in Forward with Optional Early Termination     116
Quanto Options     119
Pricing and Correlation Risk of the Option     119
Hedging FX Exposure on the Quanto Option     122
Composite Options     125
An Example of the Composite Option     125
Hedging FX Exposure on the Composite Option     126
Outperformance Options     129
Example of an Outperformance Option      129
Outperformance Option Described as a Composite Option     130
Correlation Position of the Outperformance Option     131
Hedging of Outperformance Options     132
Best of and Worst of Options     135
Correlation Risk for the Best of Option     135
Correlation Risk for the Worst of Option     137
Hybrids     138
Variance Swaps     139
Variance Swap Payoff Example     140
Replicating the Variance Swap with Options     140
Greeks of the Variance Swap     142
Mystery of Gamma Without Delta     144
Realised Variance Volatility versus Standard Deviation     145
Event Risk of a Variance Swap versus a Single Option     146
Relation Between Vega Exposure and Variance Notional     147
Skew Delta     147
Vega Convexity     148
Dispersion     151
Pricing Basket Options     151
Basket Volatility Derived From its Constituents     152
Trading Dispersion     153
Quoting Dispersion in Terms of Correlation     153
Dispersion Means Trading a Combination of Volatility and Correlation     153
Ratio'd Vega Dispersion     155
Skew Delta Position Embedded in Dispersion     156
Engineering Financial Structures     157
Capital Guaranteed Products     157
Attractive Market Conditions for Capital Guaranteed Products     158
Exposure Products for the Cautions Equity Investor     160
Leveraged Products for the Risk Seeking Investor     163
Variance of a Composite Option and Outperformance Option     167
Replicating the Variance Swap     169
Bibliography     175
Index     177