Option Markets, Valuation, and Hedging
Options can be compared to forward contracts where one of the counterparties pays a premium for the option to settle or not to settle. Options have become popular both on the OTC and on the organized exchange markets, but their valuation is more complex t
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Option Markets, Valuation, and Hedging
4.1
Options Mechanics and Elementary Properties
Forwards can be used by financial managers to fix the price of an asset in the future. As for other basic assets, derivative traders on the financial markets can be classified as market-makers and market-users. Market-makers buy and sell the instruments to make a profit on the differences between the buying (bid) and selling (ask/offer) prices. Their existence is important for the liquidity of the markets. Market users, on the other hand, from time to time just use the market to hedge, speculate, or perform arbitrage. By the term hedging, we mean entering into a new contract that will reduce our risk in one or more underlying assets. On the other hand, a speculative transaction will create or increase the risk, while arbitrage would be a combination of two or more transactions that generate a profit without any risk. Let us illustrate these concepts with a few examples. Example 1.1 If a company enters into a long forward position and if, at maturity, the market price is above the fixed forward price, then everybody is happy. But if the market price falls below the fixed price, then the financial manager might face unpleasant criticism. Thus, it is natural that some financial managers prefer to keep only the upside potential and have an option not to apply the forward rate in the downside scenario. This need is exactly satisfied by the options as illustrated in Example 1.2. Generally, there is an option holder and an option underwriter, or seller. The (call or put) option holder has the right, but not an obligation, to buy or sell an underlying asset at a fixed (exercise or strike) price K. Unlike forwards, there is an initial payment of the option premium to the option seller, since the option seller keeps only the downside, while the option holder keeps only the upside. A European option can be exercised only at maturity (expiration date), while an American option can be exercised any time up to the expiration date. Options are traded on organized # The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2020 J. Witzany, Derivatives, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-51751-9_4
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Option Markets, Valuation, and Hedging
exchanges (usually in parallel with futures on the same underlying) and over the counter (OTC)—mostly FX and exotic options. When options are traded, it is the premium that is negotiated, while the strike price, maturity, and option type are the agreed parameters of the option. Figure 4.1 shows a selection of August 2019 Gold option prices traded on the CME. More options could be shown for other future maturities. There are many options even for the single maturity, although not all possible strike prices are listed and traded on the exchange. The number of options on the OTC market would be potentially unlimited, since option parameters are individually set between any two counterparties. The options in Fig. 4.1 can be g
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