As mentioned in previous chapters, options provide investors and financial engineers with flexible tools for achieving specific investment goals. Exotic options are nonstandardized instruments, tailor-made in private, over-the-counter (OTC) transactions and designed to capture specific market opportunities. They are often referred to as exotics because of their unique structure and relative complexity compared to standardized options. Despite the lack of standardization, however, they are not difficult to understand. They are valued and priced in the same way as standardized options are (e.g., using the strike price, the current index level or asset price, interest rate, dividend or coupon rate of the underlying asset, term over which the option or warrant is in effect, and the implied price volatility of the underling asset). A variety of exotic securities, such as flex options and reset warrants, are presently available to the public and traded on national securities exchanges in the United States.
Basket options, sector options, and related warrants are based on specific, custom-made portfolios of equities, currencies, commodities, and bonds that are bundled, usually to exploit fast-moving market events. For example, because of falling oil prices, an investor might want to purchase a call warrant that increases in value based on a basket of 10 of the largest international airline stocks. The hope is that airline stock prices will rise in anticipation of a decrease in variable fuel costs and result in higher profits.
Incidentally, there is a legal distinction between options and warrants. Warrants are often referred to as long-term options. Options traditionally cover time periods of less than a year, warrants usually over a year. Standardized, exchange-listed options in the United States are issued by, and settlement is guaranteed by, the Options Clearing Corp., a clearinghouse owned by a group of brokerdealers and other financial institutions. Investor participation in standardized options (i.e., open interest) builds over time. Alternatively, warrants and OTC options are issued by and subject to the creditworthiness of corporate issuers. They are usually sold via underwritten transactions to a large number of investors (which creates the equivalent of an immediate "open interest") or through private placements to individuals or small groups of investors.
Stock baskets on which basket options, sector options and warrants are based usually include a relatively small number of constituent stocks (e.g., 5 to 50 stocks) that may be in the same industry or part of a central investment theme (e.g., "takeover" stocks). On the other hand, broad-based indices (on which the equity index warrants discussed in Chapter 5 are based) usually represent an entire market and usually include a greater number of stocks (e.g., as few as 20 and up to thousands of stocks, such as the S&P 500 Index or the Russell 2000 Index). Basket and sector options and warrants often combine U.S., international, or custom-made combinations of assets or stocks (e.g., airlines, oil companies, international government bonds, etc.). The periodic movement of price levels of stock baskets can be based on continuous index calculations using real-time price information or once-per-day calculations using closing prices at the end of daily trading.
Like other option and warrant structures, exotic options and warrants based on stock baskets can be custom-made for investors with strikes in, at, or out-of-the-money: puts, calls, spreads, strangles, or straddles. They offer investors a way to capture leveraged returns (i.e., the ability to receive investment returns that are many times greater than the underlying cash market) based on their particular economic or market views or specific research reports. Structured products based on stock baskets offer investors a convenient way to gain exposure to a desired industry group or segment without having to engage in individual stock picking and without the transaction costs associated with assembling a portfolio of equities.
The exotic options and warrants discussed in this chapter are tailor-made for transactions designed to capture specific market opportunities. They are usually used by specific types of investment professionals that are familiar with option strategies and transactions. Exotic structures are sometimes built into structured notes, for example, whereby certain reset features allow an index level to be reset at some future point in time. By and large, however, they remain outside the mainstream of investment products, but a familiarity with their characteristics is useful in gaining an understanding of structured products.
A very general discussion of swaps contracts is introduced in Chapter 10. Swaps are private agreements among counterparties and, like exotic options and warrants, are used predominantly by institutional clients and high net-worth investors in private transactions. Usually, one party wants to minimize or fix its exposure to price fluctuations of an underlying asset, and a counterparty is willing to accept exposure to floating price movements. Swaps agreements allow such parties to, in essence, exchange cash flows relating to the market price movements of an underlying asset or assets to achieve desired investment objectives, be they speculative or rigidly conservative in nature. They are highly flexible instruments that are designed to satisfy the specific needs of the parties involved.
Due to their private nature, it is difficult to measure the size of the international swap market, which is one reason for concern by some regulators. The notional amount of assets controlled by swap agreements is estimated to be in the hundreds of billions of dollars worldwide. The international swap market is also known to be extremely efficient, highly intolerant of excessive credit risk, and brutally punitive with regard to parties that default in their obligations under swap contracts.
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