OTHER DERIVATIVES Exotic options are options with rules governing the payoff that are more complicated

than standard options. We have discussed 12 different types of exotic options: packages, nonstandard American options, forward start options, compound options, chooser options, barrier options, binary options, lookback options, shout options, Asian options, options to exchange one asset for another, and options involving several assets. We have discussed how these can be valued using the same assumptions as those used to derive the Black-Schole model. Some can be valued analytically, but using much more complicated formulas than those for regular Eur-opean calls and puts, some can be handled using analytic approximations, and some can be valued using extensions of the numerical procedures. We will present more numerical procedures for valuing exotic options. Some exotic options are easier to hedge than the corresponding regular options; others are more difficult. In general, Asian options are easier to hedge because the payoff becomes progressively more certain as we approach maturity. Barrier options can be more difficult to hedge because delta is discontinuous at the barrier. One approach to hedging an exotic option, known as static options replication, is to find a portfolio of regular options whose value matches the value of the exotic option on some boundary. The exotic option is hedged by shorting this portfolio. This chapter has shown that when there are risks to be managed, derivative markets have been very innovative in developing products to me the needs of market participants. In the weather derivatives market, two measures, HDD (Heating degree days) and CDD (Cooling degree days), have been developed to describe the temperature during a month. These are used to define the payoffs on both exchange-traded and over-the counter derivatives. No doubt, as the weather derivatives market develops, we will see contracts on rainfall, snow, and similar variables become more commonplace. In energy markets, oil derivatives have important for some time and play a key role in helping oil producers and oil consumers manage their price risk. Natural gas and electricity derivatives are relatively new. They became important for risk management when these markets were deregulated and government monopolies discontinued. Insurance derivatives are now beginning to be an alternative to traditional reinsurance as a way for insurance companies to manage the risk of a catastrophic event such as a hurricane or an earthquake. No doubt we will see other sorts of insurance (e.g., life insurance and automobile insurance) being securitized in a similar4 way as this market develops. Most weather, energy and insurance derivatives have, the property that percentage changes in the underlying variables have negligible correlations with market returns. This means that we can value derivatives by calculating expected payoffs using historical data and then discounting the expected payoffs at the risk-free rate.