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What Are Exotic Derivatives?

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  • Written By: Mary McMahon
  • Edited By: Kristen Osborne
  • Last Modified Date: 26 September 2016
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Exotic derivatives are financial products with complicated underlying contracts. Derivatives are based on the value of underlying assets and can vary in complexity, allowing people to control risk by buying, selling, and trading derivative contracts. In the case of exotic derivatives, the structure of the contract is not straightforward, and may be customized for a specific investor or market. This contrasts with vanilla derivatives, which have straightforward terms.

For investors, exotic derivatives create more options. People concerned with controlling and managing risk may find vanilla derivatives poorly suited or inadequate for their needs, depending on the type of risk involved. Having access to more complex contracts can allow for greater control and will also expose people to the possibility of larger profits.

There are a number of types of nonstandard derivatives, as exotic derivatives are also known. These can include lookback, basket, knock out, and average rate derivatives. The contract may require taking averages of the value of the underlying asset over time when the contract matures, rather than going on the current market price. It can also involve other calculations. When structuring these derivatives, people are careful to make sure the contract suits their needs and does not expose them to undue risk, while buyers examine terms carefully before buying with the goal of avoiding investment mistakes.

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Trading in exotic derivatives may be tightly controlled in some regions. Regulators are often concerned about risks to inexperienced investors. These members of the investment community may not be comfortable or familiar with advanced trading tactics and could be in danger if they purchase these derivatives and other complicated financial products. There are worries about not understanding terms or being able to control risk if an investor is not extremely familiar with the market and the terminology of contracts. Regulators may restrict purchasing and trading of derivatives to address these concerns.

Even for experienced traders, there is a risk of getting into trouble with exotic derivatives. As with all derivative products, the value of the underlying asset can shift, putting someone in a bad position. When the contract is complicated, this problem can be compounded or made more challenging to address. Investors working with derivatives must be alert to changing market conditions and trends so they can make trades appropriately and avoid being left holding dangerous or bad investments. Monitoring market activities through trade publications and other investor communications can help people stay on top of current market trends.

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