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Pricing and Hedging Financial Derivatives: A Guide for Practitioners by Leonardo Marroni, Irene Perdomo

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3

Derivatives: Options and Related Strategies

The previous two chapters have set the general backdrop for the book as a whole. In this chapter, we move on to derivative instruments more explicitly. Options are at the core of the derivatives markets and most of this book will be focused on pricing options and assessing the risks arising from taking an option position. The concepts presented in this chapter will be crucial to the understanding of the remainder of the book. As options are certainly one of the most important products in the derivatives space, we will analyse the basics in some detail.

3.1 CALL OPTIONS

3.1.1 Definition

A call option is a contract between two parties (the buyer and the seller). It gives the buyer the right – but not the obligation – to buy a specific quantity of a certain asset at a point in the future at a known price determined today. The known price is called the strike price or the exercise price.

On the other hand, the seller of the call option has the obligation – not the right – to sell that quantity of the asset at the strike price if the buyer decides to exercise his or her right. The seller of the option is also known as the option writer.

So, as noted above, if you buy a call option, you acquire the right to buy something in the future. You are not under an obligation to buy that something, however. You will only buy it, assuming that you are rational, if it is economically sensible to do so. If you decide to buy the asset specified in the ...

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