Historical Analysis of Exotic Options: A General Framework
Peregrine Securities, 2013
24 Pages Posted: 22 Apr 2016 Last revised: 28 Apr 2016
Date Written: March 14, 2013
Exotic options present fund managers with flexibility in constructing a hedge consistent with desired risk and return properties and forward-looking views. However, gaining an understanding of exotic instruments is difficult, particularly since the traditional method of option analysis via payoff profiles cannot be generally applied. One method of analysis that can provide valuable insight is historical performance analysis or backtesting. A flexible utility for the analysis of vanilla-hedged portfolios over specified historical periods has been developed at Peregrine Securities and demonstrated in previous research, but a similar type of analysis for exotic options presents challenges in terms of skew-consistent pricing and time-consuming pricing algorithms. We demonstrate our enhanced backtesting framework through the historical analysis of portfolios hedged with popular path-dependent variations of put spread strategies, namely down-and out and ratchet (or strike resetting) put spreads. These strategies illustrate how exotic options can be used to either increase or decrease risk, and so assist in the construction of the most appropriate hedge.
Keywords: exotic option pricing, derivative portfolio backtesting
JEL Classification: G13, G11, C1
Suggested Citation: Suggested Citation