Abstract:

In the current environment of heightened economic volatility and uncertainty, the challenges facing money management are complex. Managers and industry leaders must make the right predictions quickly, otherwise a wrong move could have disastrous consequences for the organization because of the enormous amounts of money involved. One of the most fundamental responsibilities of financial professionals is to measure and quantify the risks associated with the creation of financial derivatives. An option is a financial derivative that represents a contract sold by a seller (writer) to a buyer (holder). The contract gives the holder with the right, but not the obligation, to buy (call) or sell (put) a particular financial asset (underlying asset) at an agreed price (strike price) on a specific date (exercise date). If the holder chooses to exercise the right, the writer is obligated to sell or buy the underlying asset at the strike price on the exercise date. The holder may elect not to exercise this right and have it lapse. There are two main reasons why investors buy options: (1) speculators, as investors, can speculate on the future direction of asset prices and use options as leverage to increase returns; (2) portfolio managers, as investors, can use options to hedge their positions to protect their portfolio from adverse price movements. Options provide investors with a way to predict the future before acting. Although options are redeemed as a form of insurance to reduce the risk of the underlying asset, holding options is still risky, especially for speculators. For portfolio managers, they would be better off not wasting money on hedging. How about introducing “option insurance”? Any option holder may claim partial compensation by paying a premium before the expiration date to cover the cost of the unexercised option. Two distinct concepts, insurance and financial option, come together to create insurance for option speculators and portfolio managers, transferring the risk of potential loss from one entity to an average over a group of entities.