List two types of exotic options and describe their characteristics.
Answer: There are five exotic options mentioned in the textbook: •
Asian Options have payoffs that depend on the average price of the underlying asset during at least some portion of the life of the option. •
Barrier Options have payoffs that depend both on the asset's price at expiration and on whether the underlying asset's price has crossed through some barrier. If the asset's price crosses the barrier the option might automatically expire. Or if the asset's price does not cross the barrier the option may not pay. •
Lookback Options have payoffs linked to the maximum or minimum price during the life of the option. The option would “look back” to see what the relevant price was and the payoff would be based on that rather than on the price at the expiration date. •
Currency-Translated Options have either asset or exercise prices denoted in a foreign currency. For example, an exchange rate may be specified as the rate at which a foreign currency can be converted into dollars. •
Binary Options are based on two possible outcomes – yes or no. If a specified event happens, the option may make a payoff of a fixed amount. If the event does not happen, there may be no payoff. The opposite arrangement is also possible.
This question gives the student an opportunity to explore some of the results of financial engineering. It verifies the student's understanding of items that go beyond the basic options.
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