What is the reason hedge funds or proprietary trading firms trade exotic options? Given that they are complex OTC products, don't the banks on the other side of the trade want to make significant profits as well? So why share the profits?If profit is not the only reason, does one use exotics for hedging? Can't that be reached with combinations of vanilla options traded on the market?Thanks

Hi there,There are at least 3 reasons buy side trade exhautics:1) In many cases OTC products are cheaper. Say, in the case of a foreign exchange forward, the forward rate will be determined using the base rates for the respective currencies plus a small commission. For cash currency the borroing cost for the short currency position will be higher than the base rate and the deposit on the long position will yield less than the corresponding base rate. As a result, the cost may accumulate to as much as 20-50 basis points per year while the forward commission is just a few basis points. OTC products such as Credit Default Swaps have lower margin requirement than, say, leveraged bonds - important in the current conditions of expensive funding.2) To avoid the necessity to engage in activities outside the core business. Even if funds have expertise in hedging an exotic option with exchange traded securities/derivatives, there are strong reasons to outsource the hedging to banks so that fund managers can concentrate on the core investment activities.3) Underestimation of risks of engaging in derivative transactions

rector, could you update the link to the article? thanks!

About those long dated exotics(5-10Y), who is the customer, how to manage the risk. Bonus is still based on the P&L?

QuoteOriginally posted by: fomisharector, could you update the link to the article? thanks!The link still works for me. If it doesn't for you, just search for "Hidden Swap Fees by JPMorgan, Morgan Stanley Hit School Boards" (in quotes).

QuoteOriginally posted by: zxemAbout those long dated exotics(5-10Y), who is the customer, how to manage the risk. Bonus is still based on the P&L?See the above link. Not everyone on the buy side is bonus- or PnL-driven.

QuoteOriginally posted by: zxemAbout those long dated exotics(5-10Y), who is the customer, how to manage the risk. Bonus is still based on the P&L?Many customers are constrained and unsophisticated (meaning low tech, not meaning stupid) investors who (as pointed out below) want exposure to a single payoff and let a bank's desk manage the strategy. They tend to not be able to compute the price or the greeks themselves, so very likely they use accrual accounting for their P&L (in fact, many customers are ALM departments, insurance funds, pension funds, etc). No daily MTM, otherwise they would quickly see that exotics are inefficient from risk/return point of view (this is mostly due to the embedded fees, and high bid-offer which makes unwinding mid-way impractical). Most exotics are designed to produce high cash flows which are achieved by selling embedded optionality. This comes at a cost, of course, but to an accrual accounting driven firm, 8% coupons look like an arbitrage (the real cost often comes down the road, when the product has blown up and the customer needs to "restructure"....).Having said that, the most sophisticated alpha seeking buy side shops stick to vanillas for very good reasons.

Exotic desks try to offer more and more sophisticated products. Doing this, they get to eliminate competition from other desks, so they get more margin. They ensure that their clients don't really know what is the real value of what they are buying. Gmike2000 sais it all.Hedge Funds trading on exotics are not doing really very exotic trades. As far as I know, they trade in very well known pay offs taht can be priced with well known models so no big margins will be charged to them when trading it.