Fixed Income Markets: Management, Trading and Hedging, 2nd Edition

CHAPTER 16 Options I

As a risk-management tool, options allow banks and corporates to hedge market exposure but also to gain from upside moves in the market. This makes them unique among hedging instruments. Options have special characteristics that make them stand apart from other classes of derivatives. As they confer a right to conduct a certain transaction, but without imposing an obligation to do so, their payoff profile is different from other financial assets, both cash and off-balance-sheet. This makes an option more of an insurance policy than a pure hedging instrument, as the person who has purchased the option for hedging purposes need only exercise it if required. The price of the option is, in effect, the insurance premium that has been paid for peace of mind. Options are also used for purposes other than hedging. As part of speculative and arbitrage trading, and option market makers generate returns from managing the risk on their option books profitably. The range of combinations of options that can be dealt today, and the complex-structured products of which they form a part, is constrained only by imagination and customer requirements. Virtually all participants in capital markets will have some requirement that may be met by the use of options.

This chapter is a large one as we first introduce the basics of options and then consider the complex topic of option pricing. A subsequent chapter looks at the main sensitivity measures used in running an option book, ...