Mechanics of Options Markets
A corporate treasurer is designing a hedging program involving foreign currency options. What are the pros and cons of using (a) the NASDAQ OMX and (b) the over-the-counter market for trading?
The NASDAQ OMX offers options with standard strike prices and times to maturity. Options in the over-the-counter market have the advantage that they can be tailored to meet the precise needs of the treasurer. Their disadvantage is that they expose the treasurer to some credit risk. Exchanges organize their trading so that there is virtually no credit risk.
Suppose that a European call option to buy a share for $100.00 costs $5.00 and is held until …show more content…
The holder of an American option has the right to exercise it immediately. The American option must therefore be worth at least as much as its intrinsic value. If it were not an arbitrageur could lock in a sure profit by buying the option and exercising it immediately.
Explain carefully the difference between writing a put option and buying a call option.
Writing a put gives a payoff of [pic]. Buying a call gives a payoff of [pic]. In both cases the potential payoff is [pic]. The difference is that for a written put the counterparty chooses whether you get the payoff (and will allow you to get it only when it is negative to you). For a long call you decide whether you get the payoff (and you choose to get it when it is positive to you.)
The treasurer of a corporation is trying to choose between options and forward contracts to hedge the corporation’s foreign exchange risk. Discuss the advantages and disadvantages of each.
Forward contracts lock in the exchange rate that will apply to a particular transaction in the future. Options provide insurance that the exchange rate will not be worse than some level. The advantage of a forward contract is that uncertainty is eliminated as far as possible. The disadvantage is that the outcome with hedging can be significantly worse than the outcome with no hedging. This disadvantage is not as marked with options. However,