Fx vanilla and exotic options
Knock-out options are options that terminate if the underlying reaches a certain price. Since the option ceases to exist, there is no payoff even if the price moves back within the knock-out barrier before the original expiration.
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Thus, an option with a knock-out barrier has a maximum specified value and payoff. Single-barrier options have a single trigger price that is either above or below the strike price, and double-barrier options have trigger prices that are above and below the strike price.
Because the option may either not come into existence or pass out of existence, barrier options are generally cheaper than standard options, with the double-barrier option being cheapest. Most exotic FX options are barrier options. A double-trigger option , often used for insurance purposes, pays off only if 2 events occur. A company or an insurance company will buy this option to limit losses that are very unlikely, but would be very expensive if they both occurred.
An example would be if a company had a large property loss in a foreign country where changes in the foreign exchange rate made the loss much more expensive. Weather options pay off for unusual weather. Many businesses that are affected by the weather, such as utilities and ski resorts, use these options to keep cash flow more consistent. The Pauper's Money Book shows how you can manage your money to greatly increase your standard of living. Save, invest, and earn more money.
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Manage time effectively. Invest for maximum results with a minimum of risk. Minimize taxes. Earn tax-free income. Why would we ever buy an option with a barrier on it? Because it is cheaper than buying the vanilla option and we have a specific view about the path that spot will take over the lifetime of the structure. Intuitively, barrier options should be cheaper than their vanilla counterparts because they risk either not being knocked in or being knocked out. A double knockout option is cheaper than a single knockout option because the double knockout has two trigger prices, either of which could knock the option out of existence.
How much cheaper a barrier option is compared to the vanilla option depends on the location of the trigger.
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For a given trigger, we should note that we would expect the difference in price between the vanilla price and the knockout price to increase with moves higher in implied volatility. A higher implied volatility means that spot is more likely to trade at the trigger than if spot were less volatile. A greater likelihood of trading at the trigger means a greater likelihood of getting knocked out.
The opposite applies to knock-in options. Now, turn to the case where the barrier is in-the-money with respect to the strike. A knock-out option in which the barrier is in-the-money with respect to the strike is called a reverse knock-out option.
Exotic Options
A knock-in option in which the barrier is in-the-money with respect to the strike is called a reverse knock-in option. How do we make money with this position? For example, we would buy a cheap 1-month 1. Ideally, spot drifts higher very slowly, ending up just less than 1. We exercise the option, buying our US dollars against Canadian dollars at 1.
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American options mean greater implied volatility compared to European options. The reason is that they contain much more flexibility regarding their dates of exercise. Logically, this extra flexibility comes at the expense of a higher premium. Either the scenario happens, and the buyer wins an agreed amount, or else he has lost the premium. Typically, they are only OTC-traded.
Additionally, this type of fx option comes with a higher premium, and their calculation is less transparent. Summary : We can place forex options into two main categories. The type of traditional vanilla fx options consists of the subclasses of American and European styled forex options.
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We can trade both of them similarly to classic stock options, with Calls and Puts. The class of exotic fx options contains the groups of Barrier, digital and Asian options. Traditional Options vs.
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