Exotic Option Pricing: A Simplified Approach

This paper develops a simplified approach for obtaining the market value of exotic options. Its unique innovation is to value the term risk in exotic options - where term risk is the risk that exotic options terminate before expiry - with a small subset of the market traded volatility surface. This innovation significantly reduces model risk. Since the value of term risk is obtained directly from the market, value sensitive approximations such as: computationally expensive calibration, estimation, simulation, and optimization; and theoretically baseless constants; are redundant. As a result, the effect on exotic options of the slope in the term structure of volatility, the slope in the term-dependent skew, and the curvature in the term-dependent smile, can be valued with and hedged by a small subset of European vanilla options that expire at the duration of the exotic option. The simplified approach is tested empirically with a sample of 174 market traded prices for American binary FX options. Results are consistent with the simplified approach reflecting the actual market mechanism.