FRM Part I · FRM Exam Part I · Exotic Options
A risk manager hedges a short position in a down-and-out call using a static portfolio. The barrier is at 90, spot is 100, and the hedge portfolio values match the exotic along the barrier. If the spot touches 90 during the life of the option, what should the manager do?
The replicating portfolio is constructed to be worth about zero when the spot reaches the barrier, matching the knocked-out option. So when the barrier at 90 is touched, the manager should unwind the hedge portfolio, leaving no residual exposure. Holding it would create unwanted risk.
- AUnwind the hedge portfolio, which has value approximately zero at the barrier, matching the knocked-out optionCorrect
- BDouble the vanilla position to offset the lost delta
- CHold the portfolio unchanged until maturity since it replicates the exotic after the barrier
- DExercise the vanilla options immediately regardless of moneyness
Explanation
The replicating portfolio is built to have zero value on the barrier, matching the knocked-out option's worth of zero. When the barrier is touched, the portfolio is unwound at roughly no cost. Holding it would leave unwanted exposure.
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