Esoteric Derivatives and Structured Transactions
Derivatives are the area of the investment industry that exceeds all others in terms of growth in the number of offerings. This is in large part due to the fact that derivatives are created ex-nihlo (out of nothing). Though they require an underlying security to base their own value on, they require nothing else in terms of tangible assets.
Structured Transactions are another aspect of the investment world that are closely related to and often funded by derivatives. This phrase is often used to describe many types of derivative based assets, which are used for a variety of purposes. Asset Backed Securities (ABS), Collateralized Debt Obligations (CDO), Assurance contracts and Special Purpose Entities (SPE) are all forms of structured transactions. Most of these various financial instruments are used in funding an underlying corporation or legal entity. Investors will typically not encounter any of these items in a form they don't already recognize (such as Convertible bonds).
A "swap" is a derivative created by an exchange of two unrelated income streams. This type of derivative is mostly employed by institutional investors as a way to protect against interest rate risk. Many professional fund managers also employ swaps as a primary part of their investment strategy.
There are numerous derivatives that do not fall into easy classification. As complex derivatives have grown both in number and complexity, the term "exotic option" has been used to identify them as a whole. All of these derivatives share certain features that differentiate them from normal "vanilla options".
The payoff at maturity depends on more than just the price of the underlying asset at maturity or expiration. Instead the price values over the life of the option are used in some formula in addition to or in exclusion of the closing price. Various names for this aspect of a derivative are "digital", "range", "lookback", "asian", "barrier" or "lookback".
The option is dependent on more than one index (if an index option). These go by names such as "basket", "Himalaya", "mountain range" and "outperformance".
The use of a foreign exchange is involved in the calculation. These are usually called "quanto" or "composite".
INTEREST RATE / BOND OPTIONS
The average investor rarely encounters interest rate options. Again, institutional investors usually employ this type of option. In short, this type of option involves adjusting the interest rate based on a swap or derivative of some sort on an income stream or other debenture of some type. Often these instruments will be referred to as using the "black model" or the "Vasicek model" in terms of valuation.
These classes of options are the exotic of the exotic. Most of these options involve derivatives based upon other derivatives or a combination of derivatives based on more than one underlying asset. Another facet of these unique options is that they often include a cap on the maximum amount of profit, which can be obtained. Names such as "autocap", "caps and floors", "caplets", "floorlets", "collars", "cross-currency spreads" and "quanto" all refer to this class of options.
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.