Derivatives and Options

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Derivative (finance) Option (finance) 1 9

References
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Derivative (finance)

Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditionsin particular, dates and the resulting values of the underlying variablesunder which payments, or payoffs, are to be made between the parties.[1] [2] One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[3] Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (e.g., forward, option, swap); the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter); and their pay-off profile. Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies.

Usage
Derivatives are used by investors to: provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative;[4] speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level); hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out;[5] obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);[6] create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level).

Hedging
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk. From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would have) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another type of risk. Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according

Derivative (finance) to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset. Derivatives can serve legitimate business purposes. For example, a corporation borrows a large sum of money at a specific interest rate.[7] The rate of interest on the loan resets every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money.[8] If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.

Derivatives traders at the Chicago Board of Trade

Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low. Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the centuries-old institution.[9]

Types
OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market: Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is US$684 trillion (as of June 2008).[10] Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps

Derivative (finance) (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform. Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange.[11] A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's largest[12] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

Common derivative contract types

There are three major classes of derivatives: 1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves. 2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction. 3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.

Derivative (finance)

Examples
The overall derivatives market has five major classes of underlying asset: interest rate derivatives (the largest) foreign exchange derivatives credit derivatives equity derivatives commodity derivatives

Some common examples of these derivatives are:

UNDERLYING Exchange-traded futures Equity DJIA Index future Single-stock future CONTRACT TYPES Exchange-traded options Option on DJIA Index future Single-share option Option on Eurodollar future Option on Euribor future OTC swap OTC forward OTC option

Equity swap

Back-to-back Repurchase agreement

Stock option Warrant Turbo warrant

Interest rate

Eurodollar future Euribor future

Interest rate swap Forward rate agreement Interest rate cap and floor Swaption Basis swap Bond option Credit default Repurchase agreement swap Total return swap Currency swap Currency forward Credit default option

Credit

Bond future

Option on Bond future

Foreign exchange Currency future

Option on currency future

Currency option

Commodity

WTI crude oil futures

Weather derivatives

Commodity swap Iron ore forward contract

Gold option

Other examples of underlying exchangeables are: Property (mortgage) derivatives Economic derivatives that pay off according to economic reports[13] as measured and reported by national statistical agencies Freight derivatives Inflation derivatives Weather derivatives Insurance derivatives Emissions derivatives[14]

Derivative (finance)

Valuation
Market and arbitrage-free prices
Two common measures of value are: Market price, i.e., the price at which traders are willing to buy or sell the contract; Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts; see rational pricing.

Determining the market price

For exchange-traded derivatives, market price is usually transparent, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.

[15] Total world derivatives from 19982007 compared to total world wealth in the year [16] 2000

Determining the arbitrage-free price

The arbitrage-free price for a derivatives contract can be complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. For futures/forwards the arbitrage free price is relatively straightforward, involving the price of the underlying together with the cost of carry (income received less interest costs), although there can be complexities. However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the BlackScholes formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model. OTC represents the biggest challenge in using models to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the theoretical valuation. And most of the model's results are input-dependant (meaning the final price depends heavily on how we derive the pricing inputs).[17] Therefore it is common that OTC derivatives are priced by Independent Agents that both counterparties involved in the deal designate upfront (when signing the contract).

Criticism
Derivatives are often subject to the following criticisms:

Risk
The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as:

Derivative (finance) American International Group (AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on Credit Default Swaps (CDS).[18] The US federal government then gave the company US$85 billion in an attempt to stabilize the economy before an imminent stock market crash. It was reported that the gifting of money was necessary because over the next few quarters, the company was likely to lose more money. The loss of US$7.2 Billion by Socit Gnrale in January 2008 through mis-use of futures contracts. The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted. The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998. The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG.[19] The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[20] UBS AG, Switzerlands biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September, 2011. [21]

Counter-party risk
Some derivatives (especially swaps) expose investors to counter-party risk. Different types of derivatives have different levels of counter-party risk. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; banks that help businesses swap variable for fixed rates on loans may do credit checks on both parties. However, in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Large notional value

Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator. (See Berkshire Hathaway Annual Report for 2002) [22]

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations, thereby curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the 1920s30s Great Depression. (See Berkshire Hathaway Annual Report for 2002)

Benefits
The use of derivatives also has its benefits: Derivatives facilitate the buying and selling of risk, and many financial professionals consider this to have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility.

Derivative (finance)

Government regulation
In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, Gary Gensler, the chairman of the Commodity Futures Trading Commission which regulates most derivatives, was quoted saying that the derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice is looking into derivatives, too. The departments antitrust unit is actively investigating 'the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,' according to a department spokeswoman."[23]

Glossary
Bilateral netting: A legally enforceable arrangement between a bank and a counter-party that creates a single legal obligation covering all included individual contracts. This means that a banks obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement. Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as credit default swaps, credit linked notes and total return swaps. Derivative: A financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof. Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures contracts and options) that are transacted on an organized futures exchange. Gross negative fair value: The sum of the fair values of contracts where the bank owes money to its counter-parties, without taking into account netting. This represents the maximum losses the banks counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the counter-parties. Gross positive fair value: The sum total of the fair values of contracts where the bank is owed money by its counter-parties, without taking into account netting. This represents the maximum losses a bank could incur if all its counter-parties default and there is no netting of contracts, and the bank holds no counter-party collateral. High-risk mortgage securities: Securities where the price or expected average life is highly sensitive to interest rate changes, as determined by the FFIEC policy statement on high-risk mortgage securities. Notional amount: The nominal or face amount that is used to calculate payments made on swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional. Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are transacted off organized futures exchanges. Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more indices and / or have embedded forwards or options. Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with non-cumulative dividends, retained earnings, and minority interests in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt, intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a banks allowance for loan and lease losses.

Derivative (finance)

References
[1] Rubinstein, Mark (1999). Rubinstein on derivatives. Risk Books. ISBN1899332537. [2] Hull, John C. (2006). Options, Futures and Other Derivatives, Sixth Edition. Prentice Hall. pp.1. [3] Kaori Suzuki and David Turner (December 10, 2005). "Sensitive politics over Japan's staple crop delays rice futures plan" (http:/ / www. ft. com/ cms/ s/ 0/ d9f45d80-6922-11da-bd30-0000779e2340. html). The Financial Times. . Retrieved October 23, 2010. [4] Shirreff, David (2004). "Derivatives and leverage" (http:/ / books. google. com/ books?id=mwirEO_f1DkC). Dealing With Financial Risk. USA: The Economist. p.23. ISBN1-57660-162-5. . Retrieved 14 September 2011. [5] Khullar, Sanjeev (2009). "Using Derivatives to Create Alpha" (http:/ / books. google. com/ books?id=uv73DVVSgAsC). In John M. Longo. Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance. Singapore: World Scientific. p.105. ISBN978-981-283-465-2. . Retrieved 14 September 2011. [6] Don M. Chance; Robert Brooks (2010). "Advanced Derivatives and Strategies" (http:/ / books. google. com/ books?id=DT0nnLDMYTgC). Introduction to Derivatives and Risk Management (8th ed.). Mason, Ohio: Cengage Learning. pp.483515. ISBN978-0-324-60120-6. . Retrieved 14 September 2011. [7] Chisolm, Derivatives Demystified (Wiley 2004) [8] Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no actual principal. [9] News.BBC.co.uk (http:/ / news. bbc. co. uk/ 2/ hi/ business/ 375259. stm), "How Leeson broke the bank BBC Economy" [10] BIS survey: The Bank for International Settlements (BIS) semi-annual OTC derivatives statistics (http:/ / www. bis. org/ statistics/ derstats. htm) report, for end of June 2008, shows US$683.7 billion total notional amounts outstanding of OTC derivatives with a gross market value of US$20 trillion. See also Prior Period Regular OTC Derivatives Market Statistics (http:/ / www. bis. org/ publ/ otc_hy0805. htm). [11] Hull, J.C. (2009). Options, futures, and other derivatives . Upper Saddle River, NJ : Pearson/Prentice Hall, c2009 [12] Futures and Options Week: According to figures published in F&O Week 10 October 2005. See also FOW Website (http:/ / www. fow. com). [13] "Biz.Yahoo.com" (http:/ / biz. yahoo. com/ c/ e. html). Biz.Yahoo.com. 2010-08-23. . Retrieved 2010-08-29. [14] FOW.com (http:/ / www. fow. com/ Article/ 1385702/ Issue/ 26557/ Emissions-derivatives-1. html), Emissions derivatives, 1 December 2005 [15] "Bis.org" (http:/ / www. bis. org/ statistics/ derstats. htm). Bis.org. 2010-05-07. . Retrieved 2010-08-29. [16] "Launch of the WIDER study on The World Distribution of Household Wealth: 5 December 2006" (http:/ / www. wider. unu. edu/ events/ past-events/ 2006-events/ en_GB/ 05-12-2006/ ). . Retrieved 9 June 2009. [17] Boumlouka, Makrem (2009),"Alternatives in OTC Pricing", Hedge Funds Review, 10-30-2009. http:/ / www. hedgefundsreview. com/ hedge-funds-review/ news/ 1560286/ otc-pricing-deal-struck-fitch-solutions-pricing-partners [18] Kelleher, James B. (2008-09-18). ""Buffett's Time Bomb Goes Off on Wall Street" by James B. Kelleher of Reuters" (http:/ / www. reuters. com/ article/ newsOne/ idUSN1837154020080918). Reuters.com. . Retrieved 2010-08-29. [19] Edwards, Franklin (1995), "Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft" (http:/ / www0. gsb. columbia. edu/ faculty/ fedwards/ papers/ DerivativesCanBeHazardous. pdf), Derivatives Quarterly (Spring 1995): 817, [20] Whaley, Robert (2006). Derivatives: markets, valuation, and risk management (http:/ / books. google. com/ books?id=Hb7xXy-wqiYC& printsec=frontcover& cad=0#v=onepage& q& f=false). John Wiley and Sons. p.506. ISBN0471786322. . [21] http:/ / www. businessweek. com/ news/ 2011-09-15/ ubs-loss-shows-banks-fail-to-learn-from-kerviel-leeson. html [22] http:/ / www. berkshirehathaway. com/ 2002ar/ 2002ar. pdf [23] Story, Louise, "A Secretive Banking Elite Rules Trading in Derivatives" (http:/ / www. nytimes. com/ 2010/ 12/ 12/ business/ 12advantage. html?hp), The New York Times, December 11, 2010 (December 12, 2010 p. A1 NY ed.). Retrieved 2010-12-12.

Further reading
John C. Hull (2011), Options, Futures and Other Derivatives, Pearson Education, 8th Edition Michael Durbin (2011), All About Derivatives, McGraw-Hill, 2nd Edition Mehraj Mattoo (1997), Structured Derivatives: New Tools for Investment Management A Handbook of Structuring, Pricing & Investor Applications (Financial Times)

External links
BBC News Derivatives simple guide (http://news.bbc.co.uk/1/hi/business/2190776.stm) European Union proposals on derivatives regulation 2008 onwards (http://ec.europa.eu/internal_market/ financial-markets/derivatives/index_en.htm) Derivatives in Africa (http://www.mfw4a.org/capital-markets/derivatives-derivatives-exchanges-commodities. html) Derivatives Litigation (http://derivatives-litigation.blogspot.com/)

Option (finance)

Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price.[1] The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset. An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The reference price at which the underlying may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless.[1] In return for assuming the obligation, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised. An option can usually be sold by its original buyer to another party. Many options are created in standardized form and traded on an anonymous options exchange among the general public, while other over-the-counter options are customized ad hoc to the desires of the buyer, usually by an investment bank.[2] [3]

Option valuation
The theoretical value of an option is evaluated according to any of several mathematical models. These models, which are developed by quantitative analysts, attempt to predict how the value of an option changes in response to changing conditions. For example how the price changes with respect to changes in time to expiration or how an increase in volatility would have an impact on the value. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments. Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other.

Contract specifications
Every financial option is a contract between the two counterparties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:[4] whether the option holder has the right to buy (a call option) or the right to sell (a put option) the quantity and class of the underlying asset(s) (e.g., 100 shares of XYZ Co. B stock) the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise the expiration date, or expiry, which is the last date the option can be exercised the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount the terms by which the option is quoted in the market to convert the quoted price into the actual premium the total amount paid by the holder to the writer of the option.

Option (finance)

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Types
The Options can be classified into following types:

Exchange-traded options
Exchange-traded options (also called "listed options") are a class of exchange-traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include:[5] [6] stock options, commodity options, bond options and other interest rate options stock market index options or, simply, index options and options on futures contracts callable bull/bear contract

Over-the-counter
Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: 1. interest rate options 2. currency cross rate options, and 3. options on swaps or swaptions.

Other option types

Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

Option styles
Naming conventions are used to help identify properties common to many different types of options. These include: European option an option that may only be exercised on expiration. American option an option that may be exercised on any trading day on or before expiry. Bermudan option an option that may be exercised only on specified dates on or before expiration. Barrier option any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised. Exotic option any of a broad category of options that may include complex financial structures.[7] Vanilla option any option that is not exotic.

Option (finance)

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Valuation models
The value of an option can be estimated using a variety of quantitative techniques based on the concept of risk neutral pricing and using stochastic calculus. The most basic model is the Black-Scholes model. More sophisticated models are used to model the volatility smile. These models are implemented using a variety of numerical techniques.[8] In general, standard option valuation models depend on the following factors: The current market price of the underlying security, the strike price of the option, particularly in relation to the current market price of the underlying (in the money vs. out of the money), the cost of holding a position in the underlying security, including interest and dividends, the time to expiration together with any restrictions on when exercise may occur, and an estimate of the future volatility of the underlying security's price over the life of the option. More advanced models can require additional factors, such as an estimate of how volatility changes over time and for various underlying price levels, or the dynamics of stochastic interest rates. The following are some of the principal valuation techniques used in practice to evaluate option contracts.

Black-Scholes
Following early work by Louis Bachelier and later work by Edward O. Thorp, Fischer Black and Myron Scholes made a major breakthrough by deriving a differential equation that must be satisfied by the price of any derivative dependent on a non-dividend-paying stock. By employing the technique of constructing a risk neutral portfolio that replicates the returns of holding an option, Black and Scholes produced a closed-form solution for a European option's theoretical price.[9] At the same time, the model generates hedge parameters necessary for effective risk management of option holdings. While the ideas behind the Black-Scholes model were ground-breaking and eventually led to Scholes and Merton receiving the Swedish Central Bank's associated Prize for Achievement in Economics (a.k.a., the Nobel Prize in Economics),[10] the application of the model in actual options trading is clumsy because of the assumptions of continuous (or no) dividend payment, constant volatility, and a constant interest rate. Nevertheless, the Black-Scholes model is still one of the most important methods and foundations for the existing financial market in which the result is within the reasonable range.[11]

Stochastic volatility models

Since the market crash of 1987, it has been observed that market implied volatility for options of lower strike prices are typically higher than for higher strike prices, suggesting that volatility is stochastic, varying both for time and for the price level of the underlying security. Stochastic volatility models have been developed including one developed by S.L. Heston.[12] One principal advantage of the Heston model is that it can be solved in closed-form, while other stochastic volatility models require complex numerical methods.[12]

Model implementation
Further information: Valuation of options Once a valuation model has been chosen, there are a number of different techniques used to take the mathematical models to implement the models.

Analytic techniques
In some cases, one can take the mathematical model and using analytical methods develop closed form solutions such as Black-Scholes and the Black model. The resulting solutions are readily computable, as are their "Greeks".

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Binomial tree pricing model

Closely following the derivation of Black and Scholes, John Cox, Stephen Ross and Mark Rubinstein developed the original version of the binomial options pricing model.[13] [14] It models the dynamics of the option's theoretical value for discrete time intervals over the option's life. The model starts with a binomial tree of discrete future possible underlying stock prices. By constructing a riskless portfolio of an option and stock (as in the Black-Scholes model) a simple formula can be used to find the option price at each node in the tree. This value can approximate the theoretical value produced by Black Scholes, to the desired degree of precision. However, the binomial model is considered more accurate than Black-Scholes because it is more flexible; e.g., discrete future dividend payments can be modeled correctly at the proper forward time steps, and American options can be modeled as well as European ones. Binomial models are widely used by professional option traders. The Trinomial tree is a similar model, allowing for an up, down or stable path; although considered more accurate, particularly when fewer time-steps are modelled, it is less commonly used as its implementation is more complex.

Monte Carlo models

For many classes of options, traditional valuation techniques are intractable because of the complexity of the instrument. In these cases, a Monte Carlo approach may often be useful. Rather than attempt to solve the differential equations of motion that describe the option's value in relation to the underlying security's price, a Monte Carlo model uses simulation to generate random price paths of the underlying asset, each of which results in a payoff for the option. The average of these payoffs can be discounted to yield an expectation value for the option.[15] Note though, that despite its flexibility, using simulation for American styled options is somewhat more complex than for lattice based models.

Finite difference models

The equations used to model the option are often expressed as partial differential equations (see for example BlackScholes PDE). Once expressed in this form, a finite difference model can be derived, and the valuation obtained. A number of implementations of finite difference methods exist for option valuation, including: explicit finite difference, implicit finite difference and the Crank-Nicholson method. A trinomial tree option pricing model can be shown to be a simplified application of the explicit finite difference method. Although the finite difference approach is mathematically sophisticated, it is particularly useful where changes are assumed over time in model inputs for example dividend yield, risk free rate, or volatility, or some combination of these that are not tractable in closed form.

Other models
Other numerical implementations which have been used to value options include finite element methods. Additionally, various short rate models have been developed for the valuation of interest rate derivatives, bond options and swaptions. These, similarly, allow for closed-form, lattice-based, and simulation-based modelling, with corresponding advantages and considerations.

Risks
As with all securities, trading options entails the risk of the option's value changing over time. However, unlike traditional securities, the return from holding an option varies non-linearly with the value of the underlying and other factors. Therefore, the risks associated with holding options are more complicated to understand and predict. In general, the change in the value of an option can be derived from Ito's lemma as:

Option (finance) where the Greeks , , and , are the standard hedge parameters calculated from an option valuation model, and are unit changes in the underlying's price, the underlying's volatility

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such as Black-Scholes, and and time, respectively.

Thus, at any point in time, one can estimate the risk inherent in holding an option by calculating its hedge parameters and then estimating the expected change in the model inputs, , and , provided the changes in these values are small. This technique can be used effectively to understand and manage the risks associated with standard options. For instance, by offsetting a holding in an option with the quantity of shares in the underlying, a trader can form a delta neutral portfolio that is hedged from loss for small changes in the underlying's price. The corresponding price sensitivity formula for this portfolio is:

Example
A call option expiring in 99 days on 100 shares of XYZ stock is struck at $50, with XYZ currently trading at $48. With future realized volatility over the life of the option estimated at 25%, the theoretical value of the option is $1.89. The hedge parameters , , , are (0.439, 0.0631, 9.6, and 0.022), respectively. Assume that on the following day, XYZ stock rises to $48.5 and volatility falls to 23.5%. We can calculate the estimated value of the call option by applying the hedge parameters to the new model inputs as:

Under this scenario, the value of the option increases by $0.0614 to $1.9514, realizing a profit of $6.14. Note that for a delta neutral portfolio, where by the trader had also sold 44 shares of XYZ stock as a hedge, the net loss under the same scenario would be ($15.86).

Pin risk
A special situation called pin risk can arise when the underlying closes at or very close to the option's strike value on the last day the option is traded prior to expiration. The option writer (seller) may not know with certainty whether or not the option will actually be exercised or be allowed to expire worthless. Therefore, the option writer may end up with a large, unwanted residual position in the underlying when the markets open on the next trading day after expiration, regardless of their best efforts to avoid such a residual.

Counterparty risk
A further, often ignored, risk in derivatives such as options is counterparty risk. In an option contract this risk is that the seller won't sell or buy the underlying asset as agreed. The risk can be minimized by using a financially strong intermediary able to make good on the trade, but in a major panic or crash the number of defaults can overwhelm even the strongest intermediaries.

Trading
The most common way to trade options is via standardized options contracts that are listed by various futures and options exchanges. [16] Listings and prices are tracked and can be looked up by ticker symbol. By publishing continuous, live markets for option prices, an exchange enables independent parties to engage in price discovery and execute transactions. As an intermediary to both sides of the transaction, the benefits the exchange provides to the transaction include: fulfillment of the contract is backed by the credit of the exchange, which typically has the highest rating (AAA), counterparties remain anonymous,

Option (finance) enforcement of market regulation to ensure fairness and transparency, and maintenance of orderly markets, especially during fast trading conditions. Over-the-counter options contracts are not traded on exchanges, but instead between two independent parties. Ordinarily, at least one of the counterparties is a well-capitalized institution. By avoiding an exchange, users of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. In addition, OTC option transactions generally do not need to be advertised to the market and face little or no regulatory requirements. However, OTC counterparties must establish credit lines with each other, and conform to each others clearing and settlement procedures. With few exceptions,[17] there are no secondary markets for employee stock options. These must either be exercised by the original grantee or allowed to expire worthless.

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The basic trades of traded stock options (American style)

These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging. An option contract in US markets usually represents 100 shares of the underlying security.[18]

Long call
A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just purchase the stock itself. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium (price) paid, he will profit. If the stock price at expiration is lower than the exercise price, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same asd amount of money, he can control (leverage) a much larger number of shares.

Payoff from buying a call.

Long put
A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option). He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid, he will profit. If the stock price at expiration is above the exercise price, he will let the put contract expire worthless and only lose the premium paid.

Payoff from buying a put.

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Short call
A trader who believes that a stock price will decrease, can sell the stock short or instead sell, or "write," a call. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited.
Payoff from writing a call.

Short put
A trader who believes that a stock price will increase can buy the stock or instead sell, or "write", a put. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price at expiration is above the exercise price, the short put position will make a profit in the amount of the premium. If the stock price at expiration is below the exercise price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the full value of the stock. A benchmark index for the performance of a cash-secured short put option position is the CBOE S&P 500 PutWrite Index (ticker PUT).

Payoff from writing a put.

Option strategies
Combining any of the four basic kinds of option trades (possibly with different exercise prices and maturities) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several. Strategies are often used to engineer a particular risk profile to movements in the underlying security. For example, buying a butterfly spread (long one X1 call, short two X2 calls, and long one X3 call) allows a trader to profit if the stock price on the expiration date is near the middle exercise price, X2, and does not expose the trader to a large loss.

Payoffs from buying a butterfly spread.

An Iron condor is a strategy that is similar to a butterfly spread, but with different strikes for the short options offering a larger likelihood of profit but with a lower net credit compared to the butterfly spread.

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Selling a straddle (selling both a put and a call at the same exercise price) would give a trader a greater profit than a butterfly if the final stock price is near the exercise price, but might result in a large loss. Similar to the straddle is the strangle which is also constructed by a call and a put, but whose strikes are different, reducing the net debit of the trade, but also reducing the risk of loss in the trade. One well-known strategy is the covered call, in which a trader buys a stock (or holds a previously-purchased long stock position), and sells a call. If the stock price rises above the exercise price, the call will be exercised and the trader will get a fixed profit. If the stock price falls, the call will not be exercised, and any loss incurred to the trader will be partially offset by the premium received from selling the call. Overall, the payoffs match the payoffs from selling a put. This relationship is known as put-call parity and offers insights for financial theory. A benchmark index for the performance of a buy-write strategy is the CBOE S&P 500 BuyWrite Index (ticker symbol BXM).
Payoffs from selling a straddle.

Payoffs from a covered call.

Historical uses of options

Contracts similar to options are believed to have been used since ancient times. In the real estate market, call options have long been used to assemble large parcels of land from separate owners; e.g., a developer pays for the right to buy several adjacent plots, but is not obligated to buy these plots and might not unless he can buy all the plots in the entire parcel. Film or theatrical producers often buy the right but not the obligation to dramatize a specific book or script. Lines of credit give the potential borrower the right but not the obligation to borrow within a specified time period. Many choices, or embedded options, have traditionally been included in bond contracts. For example many bonds are convertible into common stock at the buyer's option, or may be called (bought back) at specified prices at the issuer's option. Mortgage borrowers have long had the option to repay the loan early, which corresponds to a callable bond option. In London, puts and "refusals" (calls) first became well-known trading instruments in the 1690s during the reign of William and Mary.[19] Privileges were options sold over the counter in nineteenth century America, with both puts and calls on shares offered by specialized dealers. Their exercise price was fixed at a rounded-off market price on the day or week that the option was bought, and the expiry date was generally three months after purchase. They were not traded in secondary markets. Supposedly the first option buyer in the world was the ancient Greek mathematician and philosopher Thales of Miletus. On a certain occasion, it was predicted that the season's olive harvest would be larger than usual, and during the off-season he acquired the right to use a number of olive presses the following spring. When spring came and the olive harvest was larger than expected he exercised his options and then rented the presses out at much higher price than he paid for his 'option'.[20] [21]

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References
[1] Pascucci, Andrea. Pde and Martingale Methods in Option Pricing. Berlin: Springer, 2011. [2] Brealey, Richard A.; Myers, Stewart (2003), Principles of Corporate Finance (7th ed.), McGraw-Hill, Chapter 20 [3] Hull, John C. (2005), Options, Futures and Other Derivatives (excerpt by Fan Zhang) (http:/ / fan. zhang. gl/ ecref/ options) (6th ed.), Pg 6: Prentice-Hall, ISBN 0131499084, [4] (PDF) Characteristics and Risks of Standardized Options (http:/ / www. theocc. com/ publications/ risks/ riskstoc. pdf). Options Clearing Corporation. . Retrieved 2007-06-21. [5] Trade CME Products (http:/ / www. cme. com/ trading/ ), Chicago Mercantile Exchange, , retrieved 2007-06-21 [6] ISE Traded Products (http:/ / web. archive. org/ web/ 20070511003741/ http:/ / www. iseoptions. com/ products_traded. aspx), International Securities Exchange, archived from the original (http:/ / www. iseoptions. com/ products_traded. aspx) on 2007-05-11, , retrieved 2007-06-21 [7] Fabozzi, Frank J. (2002), The Handbook of Financial Instruments (Page. 471) (1st ed.), New Jersey: John Wiley and Sons Inc, ISBN0-471-22092-2 [8] Reilly, Frank K.; Brown, Keith C. (2003), Investment Analysis and Portfolio Management (7th ed.), Thomson Southwestern, Chapter 23 [9] Black, Fischer and Myron S. Scholes. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy (http:/ / www. journals. uchicago. edu/ JPE/ ), 81 (3), 637654 (1973). [10] Das, Satyajit (2006), Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives (6th ed.), Prentice-Hall, Chapter 1 'Financial WMDs derivatives demagoguery,' p.22, ISBN 978-0-273-70474-4 [11] Hull, John C. (2005), Options, Futures and Other Derivatives (6th ed.), Prentice-Hall, ISBN 0131499084 [12] Jim Gatheral (2006), The Volatility Surface, A Practitioner's Guide (http:/ / www. amazon. com/ Volatility-Surface-Practitioners-Guide-Finance/ dp/ 0471792519), Wiley Finance, ISBN978-0471792512, [13] Cox JC, Ross SA and Rubinstein M. 1979. Options pricing: a simplified approach, Journal of Financial Economics, 7:229263. (http:/ / www. in-the-money. com/ artandpap/ Option Pricing - A Simplified Approach. doc) [14] Cox, John C.; Rubinstein, Mark (1985), Options Markets, Prentice-Hall, Chapter 5 [15] Crack, Timothy Falcon (2004), Basic Black-Scholes: Option Pricing and Trading (http:/ / www. BasicBlackScholes. com/ ) (1st ed.), pp. 91102, ISBN 0-9700552-2-6, [16] Harris, Larry (2003), Trading and Exchanges, Oxford University Press, pp.2627 [17] Elinor Mills (2006-12-12), Google unveils unorthodox stock option auction (http:/ / news. com. com/ Google+ unveils+ unorthodox+ stock+ option+ auction/ 2100-1030_3-6143227. html), CNet, , retrieved 2007-06-19 [18] invest-faq (http:/ / invest-faq. com/ cbc/ deriv-option-basics. html) or Law & Valuation (http:/ / www. wfu. edu/ ~palmitar/ Law& Valuation/ chapter 4/ 4-4-1. htm) for typical size of option contract [19] Smith, B. Mark (2003), History of the Global Stock Market from Ancient Rome to Silicon Valley, University of Chicago Press, pp.20, ISBN0-226-76404-4 [20] Mattias Sander. Bondesson's Representation of the Variance Gamma Model and Monte Carlo Option Pricing. Lunds Tekniska Hgskola 2008 [21] Aristotle. Politics.

Further reading
Fischer Black and Myron S. Scholes. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy (http://www.journals.uchicago.edu/JPE/), 81 (3), 637654 (1973). Feldman, Barry and Dhuv Roy. "Passive Options-Based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index." The Journal of Investing (http://www.iijournals.com/JOI/default.asp), (Summer 2005). Kleinert, Hagen, Path Integrals in Quantum Mechanics, Statistics, Polymer Physics, and Financial Markets, 4th edition, World Scientific (Singapore, 2004); Paperback ISBN 981-238-107-4 (also available online: PDF-files (http://www.physik.fu-berlin.de/~kleinert/b5)) Hill, Joanne, Venkatesh Balasubramanian, Krag (Buzz) Gregory, and Ingrid Tierens. "Finding Alpha via Covered Index Writing." Financial Analysts Journal (http://www.cfapubs.org/loi/faj). (Sept.-Oct. 2006). pp.2946. Moran, Matthew. Risk-adjusted Performance for Derivatives-based Indexes Tools to Help Stabilize Returns. The Journal of Indexes (http://www.indexuniverse.com/JOI/). (Fourth Quarter, 2002) pp.34 40. Reilly, Frank and Keith C. Brown, Investment Analysis and Portfolio Management, 7th edition, Thompson Southwestern, 2003, pp.9945. Schneeweis, Thomas, and Richard Spurgin. "The Benefits of Index Option-Based Strategies for Institutional Portfolios" The Journal of Alternative Investments (http://www.iijournals.com/JAI/), (Spring 2001), pp.44 52.

Option (finance) Whaley, Robert. "Risk and Return of the CBOE BuyWrite Monthly Index" The Journal of Derivatives (http:// www.iijournals.com/JOD/), (Winter 2002), pp.35 42. Bloss, Michael; Ernst, Dietmar; Hcker Joachim (2008): Derivatives An authoritative guide to derivatives for financial intermediaries and investors Oldenbourg Verlag Mnchen ISBN 978-3-486-58632-9 Espen Gaarder Haug & Nassim Nicholas Taleb (2008): "Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula" (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1012075&rec=1& srcabs=5771)

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External links
Robert Shiller: Video lecture about Option Markets (http://www.academicearth.org/lectures/options-markets) List of equities with options (http://www.cboe.com/TradTool/Symbols/SymbolEquity.aspx)

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Article Sources and Contributors

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