FX First Generation Exotics
A term used widely, but never and nowhere clearly defined. Today let me explain some approaches to classify and define this famous set of derivatives contracts.
For the sake of example we consider EUR/USD – the most liquidly traded currency pair in the foreign exchange market. Internationally active market participants are always subject to changing foreign exchange rates. To hedge this exposure an immense variety of derivatives transactions are traded worldwide. Besides vanilla (European style put and call) options, the so-called first generation exotics have become standard derivative instruments.
The term first generation exotic does not refer to a clearly defined set of derivatives contracts, especially not in a legal sense. However, it is universally agreed that Foreign Exchange Transactions (spot and forward contracts) and vanilla options are not in the set. It is also universally agreed that flip-flop-kiko-tarns and correlation swaps are not in the set either. We can then classify first generation exotics by:
- Time of Introduction: Here we consider the history and the time when certain contracts first traded.
- Existence of Standardized Deal Confirmations: We would classify a transaction as first generation exotic if there exists a standardized deal confirmation template, such as the ones provided by ISDA.
- Replicability: We would classify a transaction as first generation exotic if it can be statically or semi-statically replicated or approximated by spot, forward and vanilla option contracts.
- Trading Volume: We would classify a transaction as first generation exotic, if its trading volume is sufficiently high (and the transaction is not a spot, forward or vanilla option).
There can also be other approaches to classify first generation exotics. I would like to point out that a first generation exotic does not necessarily need to be a currency option. For example, a flexi forward can be considered a first generation exotic in terms of both timing and standardization, but is clearly not an option. A variance swap can be considered a first generation exotic in terms of both standardization and replicability, but is clearly not an option, because there is no right to exercise. Classification by trading volume would change the set of first generation exotics over time and is consequently not suitable for classification purposes. The various classifications would generate overlaps as well as differences. One could certainly argue to label barrier options as first generation exotic, because they would satisfy all of the above: timing, standardization, replicability and volume. For Asian options, the timing criterion would make them first generation as they started trading in Tokyo in 1987, but there is — even in 2017 — no standardized deal confirmation provided by ISDA. Power options satisfy timing and replicability, but not standardization or trading volume.
This leads to the effect that the transition between the generations is not strict and can depend on the person you ask and classification the respective person has in mind. A clean approach to classification could be sticking to the standardization, which would classify barrier options and touch products, as well as variance and volatility swaps as first generation exotic, based on the existing ISDA Definitions and their supplements. The question which transaction is standardized can then be viewed in light of ISDA’s Barrier Option Supplement, which appeared in 2005 and ISDA’s Volatility and Variance Swap Supplement, which appeared in 2013.
ISDA has extended the 1998 FX and Currency Options Definitions to the range of touch products and single and double barrier options, including time windows for barriers. These are
- options that knock in or out if the underlying hits a barrier (or one of two barriers) and
- all kind of touch products: a one-touch [no-touch] pays a fixed amount of either USD or EUR if the spot ever [never] trades at or beyond the touch-level and zero otherwise. Double one-touch and no-touch contracts work the same way but have two barriers.
The 2005 ISDA Barrier Option Supplement contains all the relevant definitions required to confirm these transactions by standardized short templates. It is clearly defined what a barrier event or a determination agent is. However, for purposes of classification, the product range covered by this ISDA supplement is not necessarily viewed as equivalent by all market participants. Moreover, the set of first generation exotics would then change each time ISDA publishes a new supplement.
My personal preference is to classify the set of first generation exotics by the time of introduction in the market. These would then include the Asian options that started trading in Tokyo in 1987, barrier options and touch contract introduced commercially in the 1990s, along with compound options. I still remember this list from a flyer that Citibank had produced in 1992 to expand their FX Options business with this new generation of products that had just gone live.
To turn final: did you ever try to use the 1998 ISDA FX and Currency Option Definitions to confirm a European Digital? A currency option as a legal contract constitutes the right to exercise for the holder of the option, and upon exercise a cash-flow is triggered: The holder pays the Call Currency Amount to the seller, and the sell pays the Put Currency Amount to the holder. The ratio of these two amounts is generally referred to as the strike price. Now, a quant, thinking that a European digital is just another contract with a different path-independent payoff, much like a vanilla option’s payoff, will face difficulties squeezing this contract into the Currency Option framework. The Put Currency Amount is zero, and hence, the holder would naturally always exercise. For this reason, it is not uncommon to confirm a European digital as an obligation to pay for the seller rather than a holder’s right to exercise and receive. I am sure you expected that anyway.
I would like to thank our readers, team, business partners and clients for the valuable impulses this year, wish you all a wonderful holiday season and good spirit for 2018.
Uwe Wystup, Managing Director of MathFinance
ISDA 1998 FX and Currency Option Definitions
ISDA 2005 Barrier Option Supplement
ISDA 2013 Volatility Swap and Variance Swap Supplement
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