An exotic derivative, in finance, is a derivative which is more complex than commonly traded “vanilla” products, usually relating to determination of payoff. The category may also include derivatives with a non-standard subject matter (i.e.underlying), developed for a particular client or a particular market.
The term has no precise meaning: the definition is dependent on time and place. Interest rate- and currency-swaps were considered exotic when they first appeared in the 1980s, but are now standard financial tools. Similarly, proprietary products originally developed by merchant banks or other financial institutions to meet the needs of particular clients may in time diffuse more widely into the market.
As regards valuation, given their complexity, exotic derivatives are usually modelled using specialized simulation- or lattice-based techniques. Often, it is possible, to “manufacture” the exotic derivative out of standard derivatives. (For example, aknockout call can be “manufactured” out of standard options; see Barrier option#Valuation.) This latter approach may then be preferred, and also allows for a benchmark against which the more specialized models may be verified.