Exotics, as they’re colloquially called, are an important part of modern-day finance. Exotic investments take many forms and have many purposes, whether they’re for hedging other positions, insuring a business operation, or speculating on a future investment movement.
These are only some of the way exotic investments are used, but they’re perhaps the most common. A typical example of an exotic investment would be commodity futures as used by airliners and oil producers. Here you can see how both firms can use the futures market to hedge their own operations in a way that is mutually beneficial for everyone involved—because it takes a lot of the uncertainty out of the market without producing an undue burden on either side of the contract.
To understand this dynamic, let’s imagine Wallyhoo Airlines and Tallyho Oil Company (note: not real companies if you hadn’t already figured that out) are both concerned about the future of oil prices. Wallyhoo has already sold tickets for 5,000 flights over the next six months spanning an average 1,500 miles per flight. That means the company has essentially locked in their own demand for 7,500,000 miles’ worth of fuel for the next six months. But what if oil shoots up in price—as it’s done in the past? Wallyhoo could buy all of the fuel it needs now and then deal with the risks of that fuel exploding in storage while also maintaining the costs of storying that fuel—or it could buy futures contracts on the fuel it needs in the future to offset its future needed expenses. If it uses those futures, it can effectively “lock in” a certain price point, guaranteeing that it will not pay more for the fuel than that price (and, if the trade is done well, possibly also offer an opportunity to buy that fuel at an even cheaper price point).
On the other side of the market we have Tallyho Oil, who have recently uncovered an oil source in the Arctic Ocean that is going to produce a lot of extra oil. Tallyho doesn’t know how much extra oil the new source will produce, but they are worried it will cause the market to become oversupplied—thus driving prices down. However, Tallyho needs to produce and distribute that oil to get much needed revenue to use to pay its bills. How can Tallyho guarantee that it sells this future stream of oil at today’s market price for oil? You guessed it—futures.
Now, in the real world, futures contracts are used in much more complex ways than what is outlined above, but this is the general idea. Companies can use commodity futures to hedge their input and output demand in the future—this is a common way commodities contracts are used. But we can also use other kinds of exotic investments to do all kinds of very complex feats of financial engineering: protect balance sheets, extend exposure while protecting from downside risks, maintain relationships with counterparties, and leverage existing positions. Many of these exotic investments are hard to understand—currency swaps, reverse repos, multi-tranche asset-backed securities—but for those who understand them, they are powerful tools to diversify portfolios, spread risk, and gain access to hard-to-reach markets.
Fully understanding and valuing exotic investments is a very long-term project. Most people with a bachelor’s in finance only have a limited understanding of these products; and even those with a CFA charter can find themselves flummoxed with some of the more complex ones. Understanding how these exotic products are used, why they exist, and how they provide investors with new investment opportunities is essential for all financial analysts of all stripes, even if none of us really understand all of them all of the time.