Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 8. Fundamentals of Options

INTRODUCTION

In Chapter 1 we saw that options on commodities such as rice, oil and grain have been in existence for many years. Options on financial assets are more recent although activity has expanded rapidly since the introduction of listed contracts on exchanges such as the Chicago Board Options Exchange (CBOE), LIFFE and Eurex. The buyer of a European-style option contract has the right but not the obligation:

• to buy (call option) or sell (put option) an agreed amount of a specified asset, called the underlying;

• at a specified price, called the exercise or strike price;

• on a future date, called the expiry or expiration date.

European options can only be exercised at expiry, whereas American-style contracts can be exercised on any business day up to and including expiry. These labels are purely historical. The majority of exchange-traded options around the world are American-style, modelled on the contracts first traded on exchanges in the USA. Over-the-counter (OTC) options are often European, because the buyers do not wish to pay extra premium for the ability to exercise before expiry. An American call on a dividend-paying share will be more expensive than a European call, since there are occasions when it is beneficial to exercise the contract early and receive the forthcoming dividend on the share. A Bermudan option is a half-way house. It can be exercised on a set number of days before expiry, such as one day per week.

Unlike a forward, an option ...