Pricing of exotic options

Abstract

A cliquet is a type of structured product which is equivalent to a collection of forward starting at-the-money options where the strike can be periodically reset to the current level of the underlying. Cliquets enable investors to lock in gains at pre-specified dates in the future when the option’s strike is effectively reset. The first cliquet options to be traded on a public exchange were S&P 500 bear market as warrants with a periodic reset. These started trading on the Chicago Board of Options Exchange in 1996. These reset warrants on the S&P 500 index work like regular equity or index puts except that the exercise price is reset at a higher level if the index level is above the original exercise price on the reset date. 1.1 Advantages of cliquet options The Cliquet is suitable for investors with a medium term investment horizon. It is less risky that ordinary medium term options as there is less specific risk, i.e the reset facility gives the buyer multiple chance to set the strike price. This increases the chance of a payout but will naturally balanced by a higher premium cost. As a series of pre-purchased options, cliquet options are attractive to passive investors as it requires no intermediate management. They have traditionally been attractive to retail and private investors when embedded in deposits and bonds as they provide a low risk (capital guaranteed) exposure to bond and equity markets. Investors may use cliquets to take advantage of assumptions of future volatility. 1.2 Objectives of the research The objective of this research is to gain an understanding of the structured products and their relevance to the Indian markets. With growing affluence among India's middle classes creating a more sophisticated and risk-hungry breed of investor, the demand for structured products is certainly on the increase. Structurers have therefore been finding ever more innovative ways of creating new products to get around the regulatory restrictions. Many of these products are now being introduced in India in note format as synthetic options. The first of these was issued by Standard Chartered in October and structured by Merrill Lynch, offering investors a cliquet option-based payoff. We have chosen to study this financial product for our Contemporary Concerns Study due to its growing popularity, limited downside, inherent complexity in the product and current relevance to the Indian market. We will discuss the valuation, benefits and market for cliquet options as part of the project.We will discuss the cliquet pricing models in the following chapters and credit default swaps in the succeeding chapters.