Derivatives Markets - Essay Example

We have already given examples of stock options in an earlier section; we now move on to index options. Stock market indices are well known, not only in the investment community but also among many individuals who are not even directly investing in the market. Because a stock index is just an artificial portfolio of stocks, it is reasonable to expect that one could create an option on a stock index. Indeed, we have already covered forward and futures contracts on stock indices; options are no more difficult in structure.

For example, consider options on the S&P 500 Index, which trade on the Chicago Board Options Exchange and have a designated index contract multiplier of 100. On 13 June of a given year the S&P 500 closed at $1241.6. A call option with an exercise price of $1250 expiring on 20 July was selling for $28. The option is European style and settles in cash. The underlying is treated as it was a share of stock worth $1241.6, which can be bought, using a call option, for $1250 on 20 July. At expiration if the option is in the money, the buyer exercises it and the writer pay the buyer the $250 contract the multiplier times the difference between the index value at expiration and $1250.

In the United States, there are also options on the Dow Jones Industrial Average, the NASDAQ, and various other indices. There are nearly always options on the best-known stock indices in most countries. Just as there are options on stocks, there are also options on bonds.Interest rate optionsAn interest rate option is an option in which the underlying is an interest rate. It has an exercise rate or strike rate, which is expressed on an order of magnitude of an interest rate. At expiration the option payoff is based on the difference between the underlying rate in the market and the exercise rate.

Example:Consider an option expiring in 90 days on 180 day LIBOR. The option buyer specifies whatever exercise rate he desires. Let us say he chooses an exercise rate of 5.5 percent and a notional principle of $10 million. Now let us move to the expiration day.Suppose 180 day LIBOR is 6%. Then the call option in-the-money. The pay off to the holder is $10000000(0.06-0.55) (180/360) =$25000BOND OPTIONSOptions on bonds usually called bond options are primarily traded in the over the counter markets.

Options exchanges have attempted to generate interest in options on bonds, but have not been very successful. Corporate bonds are not very actively traded most are purchased and held to expiration. Government bonds, however, are very actively traded nevertheless; options on them have not gained widespread acceptance on options exchanges. Options exchanges generate much of their trading volume from individual investors, who have far more interest in and understanding of stocks than bonds. Thus, bond options are found almost exclusively in the over-the-counter market and are almost on government bonds.

Consider for example, a U.S. Treasury bond maturing in 27 years. The bond has a coupon of 5.50 percent, a yield of 5.75 percent, and is selling for $0.9659 per $1 par.