I was reading Derman's latest blog post on Vanna Volga pricing, which, according to the linked Wikipedia article, is used mostly for pricing exotic options on foreign exchange (FX). This Willmott thread claims most demand for exotics is by asset-liability, pensions, and insurance firms. But this does not explain why most of the trading in these products is in FX, as opposed to equities, bonds, etc. Why are these firms trading FX exotics, and, relatedly, why are they not trading exotics in other products? Is it just the liquidity of FX vs. other markets, or is there a good fundamental reason for exotics to exist in FX and not in other markets?
As I understand it, the currency derivatives are meant for customers to hedge actual exposure. A foreign distributor obviously has exchange-rate risk, but it's hard to say who actually has risk exposure to the S&P 500. (There's the effect of beta, of course, but it's pretty rare for someone to have tangible---not just CAPM---exposure to the S&P. Someone who holds the S&P does so intentionally.)
- Since this is an asset class which is so tightly coupled with interest rates - it makes good products for clients inherently complex.
- It also makes good sense to make wider markets for more exotic products than the plain vanilla ones - in which razor-thin spreads rule (and trading huge notionals is not everyone's cup of tea)
Posting this question to a LinkedIn discussion group solicited the following additional answers:
- The underlying is relatively well understood and simple in a pricing sense. This allows you to put a complex (exotic) payoff on top.
- The vast majority of FX spot volumes are spread among a small group of G-7 currencies, unlike equities or other markets where you have a myriad of different tickers.
- No major barriers to the market / inside information / absence of manipulators (except for Central Banks who do not have speculative missions).
- Pension and insurance firms are taking deposits in one currency which they invest in a different currency for carry/performance. They only partially hedge their currency exposure using options, and sometimes exotic OTC options are designed in order to best fit their particular mix of assets and liabilities.
I do have my own question on point #2, though. Aren't there relatively few highly liquid equity indices and fixed income futures? Why don't we see more S&P 500 or US 10Y Treasury exotics?
Update: I actually like #4, which just came in from LinkedIn, best so far. Basically, the real-world exposure of unsophisticated firms is complicated, and so they offload the complex hedging to a sophisticated counterparty. This, combined with @chrisaycock's answer, completely answers the question to my satisfaction.