Finance: Capital Markets, Financial Management, and Investment Management

CHAPTER 21

Use of Options in Portfolio Management

In Chapter 6, we described the basic feature of options, their risk-return characteristics, and the basic option positions. Options provide portfolio managers with another derivative tool to manage risk and to achieve the desired investment objective. As with futures contracts described in the previous chapter, options can be used to modify the risk characteristics of an investment portfolio, to enhance the expected return of a portfolio, and to reduce transaction costs associated with managing a portfolio.

Options can be classified as listed options (also called exchange-traded options) and over-the-counter options. A couple of advantages of listed options are that they provide accurate and consistent information about pricing and virtually eliminate counterparty risk. Moreover, because of these characteristics and the standardization of products, listed options often have low transaction costs and moderate to high liquidity. The issue of transaction costs and liquidity can play an important role in the decision to use derivatives as part of the investment process. However, there has been an explosion in OTC options, which suggests that portfolio managers find these products serve an important investment purpose.

As we did in the previous chapter, we begin our discussion of the use of options in equity portfolio management and then turn to bond portfolio management. We describe the types of listed options and OTC options.