Exotic versus vanilla
AIM: Define and contrast exotic derivatives and plain vanilla derivatives.
Questions:
09.01. In comparison to a plain vanilla derivative, each of the the following is true of an EXOTIC derivative EXCEPT for (most likely answer):
a. BETTER hedge effectiveness
b. BETTER liquidity
c. LOWER basis risk
d. HIGHER (more) counterparty risk
09.02 Which is not an EXOTIC (according to Hull)?
a. Compound option
b. Bull call spread
c. Executive stock option (ESO) with four (4) year vesting
d. Option indexed to S&P 500
Answers:
09.01. In comparison to a plain vanilla derivative, each of the the following is true of an EXOTIC derivative EXCEPT for (most likely answer):
a. BETTER hedge effectiveness
b. BETTER liquidity
c. LOWER basis risk
d. HIGHER (more) counterparty risk
b. BETTER liquidity
The benefit of nonstandard terms is a better hedge but the price is typically less liquidity.
The essential difference between vanilla and exotic is similar to the difference between forward and futures: a vanilla derivative has standard terms which enables exchange trading; the exotic has non-standard terms which often requires OTC. As such, the primary (typical) trade-off is between liquidity and basis risk. A vanilla instrument will tend to have higher liquidity due to standardized terms but the exotic can be customized to LOWER basis risk (and thus giving BETTER hedge effectiveness).
09.02 Which is not an EXOTIC (according to Hull)?
a. Compound option
b. Bull call spread
c. Executive stock option (ESO) with four (4) year vesting
d. Option indexed to S&P 500
b. Bull call spread
The bull call spread is a TRADING strategy (long call plus short call with higher strike price): combinations of vanilla options are still vanilla. In regard to (c) and (d), these are American options with non-standard features.
Questions:
09.01. In comparison to a plain vanilla derivative, each of the the following is true of an EXOTIC derivative EXCEPT for (most likely answer):
a. BETTER hedge effectiveness
b. BETTER liquidity
c. LOWER basis risk
d. HIGHER (more) counterparty risk
09.02 Which is not an EXOTIC (according to Hull)?
a. Compound option
b. Bull call spread
c. Executive stock option (ESO) with four (4) year vesting
d. Option indexed to S&P 500
Answers:
09.01. In comparison to a plain vanilla derivative, each of the the following is true of an EXOTIC derivative EXCEPT for (most likely answer):
a. BETTER hedge effectiveness
b. BETTER liquidity
c. LOWER basis risk
d. HIGHER (more) counterparty risk
b. BETTER liquidity
The benefit of nonstandard terms is a better hedge but the price is typically less liquidity.
The essential difference between vanilla and exotic is similar to the difference between forward and futures: a vanilla derivative has standard terms which enables exchange trading; the exotic has non-standard terms which often requires OTC. As such, the primary (typical) trade-off is between liquidity and basis risk. A vanilla instrument will tend to have higher liquidity due to standardized terms but the exotic can be customized to LOWER basis risk (and thus giving BETTER hedge effectiveness).
09.02 Which is not an EXOTIC (according to Hull)?
a. Compound option
b. Bull call spread
c. Executive stock option (ESO) with four (4) year vesting
d. Option indexed to S&P 500
b. Bull call spread
The bull call spread is a TRADING strategy (long call plus short call with higher strike price): combinations of vanilla options are still vanilla. In regard to (c) and (d), these are American options with non-standard features.
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