Exotic Option

In finance, an exotic option is a derivative which has features making it more complex than commonly traded products (vanilla options); see Exotic derivatives. These products are usually traded over-the-counter (OTC), or are embedded in structured notes.

The term "exotic option" was popularized by Mark Rubinstein's 1990 working paper (published 1992, with Eric Reiner) "Exotic Options", with the term based either on exotic wagers in Horse racing, or due to the use of international terms such as "Asian option", suggesting the "exotic Orient".

Consider an equity index. A straight call or put, either American or European, would be considered non-exotic (vanilla). An exotic product could have one or more of the following features:

• The payoff at maturity depends not just on the value of the underlying index at maturity, but at its value at several times during the contract's life (it could be an Asian option depending on some average, a lookback option depending on the maximum or minimum, a barrier option which ceases to exist if a certain level is reached or not reached by the underlying, a digital option, peroni options, range options, spread options, etc.)
• It could depend on more than one index (as in a basket options, Himalaya options, Peroni options, or other mountain range options, outperformance options, etc.)
• There could be callability and putability rights.
• It could involve foreign exchange rates in various ways, such as a quanto or composite option.

Even products traded actively in the market can have the characteristics of exotic options, such as convertible bonds, whose valuation can depend on the price and volatility of the underlying equity, the credit rating, the level and volatility of interest rates, and the correlations between these factors.

These instruments are often created by financial engineers.