FX Exotic Options

Day One

Review of the Fundamentals
Fundamentals

• Components of foreign exchange risk: forwards, swaps and vanilla options
• FX options market: who does what and why
• Software solutions: which vendor offers what Fenics, SuperDerivatives, Bloomberg, Volmaster, Murex, ICY, Reuters

Pricing and Hedging in the Black Scholes model

• Black Scholes / Merton model in FX
• Derivation of the value of a call and put option
• Detailed discussion of the formula
• Greeks: delta, gamma, theta, rho, vega, vanna, volga, homogeneity and relationships among Greeks

Vanilla Options

• Put call parity, put call symmetry, foreign domestic symmetry
• Quotation conventions in FX, ATM and delta conventions
• Dates: trade day, premium payment day, exercise/expiration time, settlement day
• Settlement, spreads, deal processing, counterparty risk
• Exotic features: deferred payment, contingent payment, deferred delivery, cash settlement, American and Bermudan exercise rights, cut offs and fixings
• Market Data: rates, forward points, swap points, spreads

Workshop: Acquaint yourself with pricing software and market quotes

Volatility

• Implied vs. historic
• Quotation in terms of deltas
• Volatility cones
• Volatility smile: term structure, skew, risk reversals and butterflies
• Volatility sources
• Interpolation and extrapolation across the volatility smile surface: SABR, vanna volga, Reiswich Wystup
• Forward volatility

Workshop: Build your own interpolation tool for volatility smile, calculate Greeks in terms of deltas, hedging volatility risk, deriving the strike from the delta with smile

Structuring with Vanilla Options

• Risk reversal and participating forward
• Spreads and seagulls
• Straddles, strangles, butterflies, condors
• Digital options

Workshop: Structure your own seagull. Include sales margin. Solve for zero cost. Calculate delta and vega hedge. Discuss bid ask spread. Analyze smile effect

Day Two

Structuring and Vanna Volga Pricing
First Generation Exotics: Products, Pricing and Hedging

• Digital options: European and American style, single and double barrier
• Barrier options: single and double, knock in and knock out, KIKOs, exotic barrier options
• Compound and instalment
• Asian options: options on the geometric, arithmetic and harmonic mean
• Power, lookback, chooser, paylater

Workshop: Hedging a knock out with a risk reversal. Build your own semi static hedging tool, discuss forward volatility risk

Applications in Structuring

• Dual currency and other FX linked deposits
• Structured forwards: shark forward, bonus forward, range reset forward
• FX linked interest rate swaps and cross currency swaps
• Exotic spot and forward trades

Workshop: Structuring exercises: build structures, solve for zero cost, smile adjustment, bid ask spreads

Vanna Volga Pricing

• How higher order derivatives influence the price
• Vanna volga pricing approach
• Case study: one touch, one touch moustache
• Discussion of model risk and alternatives: stochastic volatility

Workshop: Pricing of barrier options with smile

Overview of Market Models

• Stochastic volatility models
• Heston 93: model properties, calibrations, pricing, pros and cons
• Local Volatility: properties, pros and cons
• Stochastic Local Volatility Hybrid models

Super Replication of barrier options: using leverage constraints and its first order approximation the barrier shift. Mixing super replication and vanna volga

Day Three

Second Generation Exotics, Pricing and Hedging issues
The Pedigree of Barrier and Touch Options

Workshop and Discussion: How to construct the universe of barrier and touch options from key building blocks: vanilla and one touch. Residual risk and limitations. Static, semi static and dynamic hedging approaches

Single Currency Exotics beyond Standard Barrier and Touch Options

• Exotic features in (vanilla) options: deferred payment, contingent payment, deferred delivery, cash settlement, American and Bermudan exercise rights, cut offs and fixings
• Exotic barrier and touch options
• Faders, corridors, accumulative forwards, target redemption forwards (TRFs)
• Forward start options, step ups
• Time options
• Variance and Volatility Swaps

Workshop: Structure and price your own accumulative forward. Smile adjustment. Simulation tool for TRFs. Discussion of TRF hedging

Multi Currency Exotics

• Product overview with applications: quanto options, baskets, spreads, best ofs, outside barriers
• Correlation: implied correlations, correlation risk and hedging, currency triangles and tetrahedra
• Pricing in Black Scholes model: analytic, binomial trees and Monte Carlo

Workshop: Pricing and correlation hedging a two currency best of: calculate your own sensitivities and hedge vega and correlation risk

Long Term FX Options (contributed usually by the Guest Speaker)

• Development of Basis Spreads
• Product Range, FX linked bonds, long term vanilla and PRDCs
• Modelling approaches
• Discussion of risk features and modelling requirements