Exotic products are usually defined by what they are not. Indeed, we tend to consider exotic products to be the opposite of plain vanilla products – those with simple return characteristics: options without discontinuities, say, or simple bonds, futures contracts or even swaps.
In finance, the term "exotic" is therefore used for financial products that are deemed marginal and are characterized by high price volatility.
An exotic product is a derivative with complex characteristics that is often used by seasoned individual investors or financial market specialists. It is created by financial institutions such as banks for end-investors who have hedging issues related to their business and are looking for a return profile that matches their market expectations. Most structured products are classified as exotic products.
Exotic derivatives involve a higher degree of difficulty due to their lack of conventional characteristics. They include most structured products, barrier options, instruments linked to market correlations and even CDOs (collateralized debt obligations).
Although exotic derivatives are sometimes traded on the financial markets, most of the time – due to their complexity and the atypical character of their underlying assets – they are traded in the over-the-counter market.
Why trade an exotic product?
Most of the time, plain vanilla products are linked to a single underlying asset. However, some traders want to trade on a basket of underlying assets, which leads to an increased complexity due to the correlation between each component of the basket.
“Himalayan options,” for example, are usually based on a basket of 16 or 20 different stocks. They are very difficult to value because of the high covariance between the components of the basket. “Worst-of” (WO) notes, which give the return on the worst-performing stock in a basket of stocks, are another type of structured product based on multiple underlying assets.
Despite the risks, the high returns provided by this type of product means they are in high demand from institutional and even private clients.