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Option term

As with futures,
options are usually short-term
(usually the maximum term to expiry is
less than a year
for a traded option).


four basic option positions an investor could hold

1. buying a call option 

2. buying a put option 

3. “writing” (ie selling) a call option 

4. “writing” (ie selling) a put option


A call option gives

gives its holder the right, but not the obligation,
to buy a specified asset
on a set date in the future
for a specified price. 


A put option gives

its holder the right, but not the obligation,
to sell a specified asset
on a set date in the future
for a specified price. 


The exercise price is

the price at which an underlying security
can be sold to (for a put) or
purchased from (for a call)
the writer or issuer of an option (
or option feature on a security).
Also known as the strike price.


The writer of an option is

the seller of that option.


To buy either a call or a put option

you pay a small amount of money up front
to the writer of the option.
This money, the option premium,
is non-returnable.


if you exercise a call option you

then have to pay the writer the exercise price.
in total you will have paid
the option premium
plus the exercise price
to buy the asset.


If you exercise a put option

the writer pays you
the exercise price for the specified asset.
in total you will have received
the exercise price
less the premium
in return for the asset.


If you choose not to exercise an option,

there are no further cash flows,
so only the premium
will have changed hands.


when options are traded

margin only required from
only one of the parties to an options contract.


Writers are required

to pay initial margin, and
will be required to pay variation margin
if the underlying asset price moves against them

up for a call writer,
down for a put writer.


most options contracts are

typically closed out
with an opposite transaction,
rather than being exercised.


Why aren’t the buyers of options required to deposit margin?

Buyers of options are not obliged to trade,
unlike the sellers of such contracts.
Buyers do not face any loss, beyond that of the initial costs (such as commission) and
thus do not pose any default risk to the clearing house.
As there is no credit risk,
no margin is required to protect the clearing house.


Over-the-counter markets consist of

Some options
Other Structured Products


OTC markets are characterised by contracts that are:

individually arranged
on a non-standardised basis
over the telephone
with banks
rather than
being traded
on a recognised exchange.


two very important OTC markets:

1. interest rate swaps
2. forward currency contracts


many transactions are now

taking place on exchanges or
are migrated to a clearing house (“cleared”)
immediately after the transaction has taken place.


Generally, a CCP will require

the parties with obligations under an OTC contract
to deposit margin.,

if a forward or a swap is centrally cleared through a CCP
it becomes more similar in nature
to a standardised contract.


Investment banks are able to tailor

a wide variety of derivatives
to suit the needs of corporate clients
and investors.


OTC markets generally

liquid and

than markets in exchange-traded derivatives and

counterparty credit risk is greater.


OTC derivatives are typically transacted under documentation:

maintained by
the International Swaps and Derivatives Association (ISDA).

ISDA documents often
can contain provisions for collateralisation and other legal terms
that can be used to manage counterparty risk.


Tailored derivatives that are available OTC include:

  Bermudian options, which
⁃ are exercisable only on specified days, and 

  Asian options,
⁃ where the payoff is based on the average value of the underlying asset over a period rather than the value at the point it is exercised.


What are the main advantages and disadvantages of the OTC market compared to exchange trading?

The main advantage of the OTC market is
⁃ ability to tailor contracts to
⁃ buyer’s precise requirements eg
⁃ with a delivery date which is different
⁃ to that of the similar exchange tradable contract.

main disadvantages of the OTC market are:
⁃   non-standard contracts
⁃ reduce or eliminate marketability 

⁃   high dealing costs 

⁃   no quoted market values 

⁃   greater credit risk
⁃ if you are not dealing with
⁃ a clearing house as guarantor. 


 What are the two types of risk associated with the use of swaps?

Market risk
is the risk that market conditions will change
so that the present value of the net outgo
under the agreement increases.
market maker will often attempt to
hedge market risk by
entering into an offsetting agreement.

Credit risk
is the risk that the other counterparty
will default on its payments.
will only occur if the swap has a negative value
to the defaulting party
so the risk is not the same as
the risk that the counterparty would default on a loan of comparable maturity.


Reason why swap credit risk is not the same as loan credit risk:

“not the same” because:
  credit risk is only a problem when the swap has a positive value to you
(a loan will always have a positive value,
whereas the value of a swap could be positive or negative) 

  even if the swap has a positive value
the problem may be quite small because:
–  the principal is not at stake
with an interest rate swap 

–  the loss of future interest income will
largely be offset by the fact that you
will no longer need to make the interest outgo payments
if your counterparty defaults; ie
you lose the net present value of the swap,
not the gross value of your payments. 

If the swap is subject to margin payments through a clearing house or Central Clearing Party (CCP), credit risk will be minimal.