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Trading and Capital-Markets Activities Manual

Instrument Profiles: Options
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)


Options transfer the right but not the obligation to buy or sell an underlying asset, instrument, or index on or before the option's exercise date at a specified price (the strike price). A call option gives the option purchaser the right but not the obligation to purchase a specific quantity of the underlying asset (from the call option seller) on or before the option's exercise date at the strike price. Conversely, a put option gives the option purchaser the right but not the obligation to sell a specific quantity of the underlying asset (to the put option seller) on or before the option's exercise date at the strike price. 

The designation ''option'' is only applicable to the buyer's status in the transaction. An option seller has an obligation to perform, while a purchaser has an option to require performance of the seller and will only do so if it proves financially beneficial. 

Options can be written on numerous instruments. Commercial banks are typically involved most with interest-rate, foreign-exchange, and some commodity options. Options can be used in bank dealer activities, in a trading account, or to hedge various risks associated with the underlying instruments or portfolio. 


A basic option has six essential characteristics, as described below. 

1. Underlying security. An option is directly linked to and its value is derived from a specific security, asset, or reference rate. Thus, options fit into the classification of ''derivative instruments.'' The security, asset, index, or rate against which the option is written is referred to as the option's underlying instrument. 

2. Strike price. The strike price is the price at which an option contract permits its owner to buy or sell the underlying instrument. The strike price is also referred to as the exercise price. A call option is said to be in the money when the price of the underlying asset exceeds the strike price. A put option is in the money when the price of the asset is less than the exercise price. 

3. Expiration date. Options are ''wasting assets''; they are only good for a pre-specified amount of time. The date after which they can no longer be exercised is known as the expiration date. 

4. Long or short position. Every option contract has a buyer and a seller. The buyer is said to have a long option position, while the seller has a short option position. This is not the same as having a long or short position in the underlying instrument, index, or rate. A bank which is long puts on government bonds has bought the right to sell government bonds at a given strike price. This gives the bank protection from falling bond prices. Conversely, if the bank were short puts, it would be obligating itself to purchase government bonds at a specific price. 

5. American or European. The two major classifications of options are American and European. American options can be exercised on any date after purchase, up to and including the final expiration date. European options can be exercised only on the expiration date of the contract. Because American options give the holder an additional privilege of early exercise, they will generally be more valuable than European options. Most exchange options are American, while most over-the-counter (OTC) options are European. 
6. Premium. The price paid for an option is referred to as the option's premium. This premium amount is a dynamic measure of the factors which affect the option's value. Therefore, options with identical contract terms can trade at a multitude of different premium levels over time. Premium has two components: time value and intrinsic value. Intrinsic value refers to the amount of value in the option if it were exercised today. Time value is the difference between the total premium and the intrinsic value; it encompasses the uncertainty of future price moves. The time value of an option is a function of the security's volatility (or risk); the current level of interest rates; and the option's maturity (or time to expiration). The option's positive time value gradually approaches zero at expiration, with the option price at expiration equal to its intrinsic value. 

For example, a long call option with a strike price of $50 on an underlying security which is trading at $52 has an intrinsic value of $2. If the option is trading for a total price of $3.50, $1.50 of the price ($3.50 - $2.00) would be time value, reflecting the fact that the underlying security may further increase in value before the option's expiration. Not all options will have an intrinsic value component; often the entire premium amount is time value. 

Exotic Options 

In the past few years, the growth of so-called ''exotic'' derivative products has been significant. Options have been no exception, and many varied types of exotic options exist today which are traded in the OTC markets. Some of the more common exotic options are discussed below. 

In general, markets for many of the exotic options are not as liquid as their more generic counterparts. Thus, a quoted price may not be a good indication of where actual liquidation of the trade could take place. 

Asian options, also called average-price options, depend on the average price of the underlying security during the life of the option. For example, a $60 call on a security which settled at $65 but traded at an average price of $63.5 during the option's life would be worth only $3.50 at expiration, not $5. Because of this feature, which essentially translates into lower volatility, Asian options tend to trade for a lower premium than conventional options. These options are generally cash settled, meaning that the actual underlying does not change hands. They belong in the category known as path-dependent options, meaning that the option's payoff depends on the path taken by the underlying security before the option's expiration. 

Barrier options, are options which either come into existence or cease to exist based on a specified (or barrier) price on the underlying instrument. This also puts them in the category of path-dependent options. The two basic types of barrier options are knock-in and knock-out. A knock-in option, either put or call, comes into existence only when the underlying asset's price reaches a specified level. A knock-out option, either put or call, ceases to exist when the barrier price is reached. 

A typical knock-in put option has a barrier price which is higher than the strike price. Thus, the put only comes into existence when and if the barrier price is reached. A knockout call barrier price is generally below the strike price. A $60 call with a $52 barrier would cease to exist if at any time during the option's life the security traded $52 or lower. Because of this cancelable feature, barrier options trade for lower premiums than conventional options. 

An important issue for barrier options is the frequency with which the asset price is monitored for the purposes of testing whether the barrier has been reached. Often the terms of the contract state that the asset price is observed once a day at the close of trading. 

Bermudan options give the holder the right to exercise on multiple but specified dates over the option's life. 

Binary options, also called digital options, are characterized by discontinuous payoffs. The option pays a fixed amount if the asset expires above the strike price, and pays nothing if it expires below the strike price. Regardless of how much the settlement price exceeds the strike price, the payoff for a binary option is fixed. 

Contingent-premium options are options on which the premium is paid only if the option expires in the money. Because of this feature, these premiums tend to be higher than those for conventional options. The full premium is also paid at expiration, regardless of how in the money the option is. Thus, the premium paid can be significantly higher than the profit returned from the option position. 

Installment options are options on which the total premium is paid in installments, with the actual option issued after the final payment. However, the buyer can cancel the payments before any payment date, losing only the premium paid to date and not the full premium amount. 

Look-back options, also in the category of path-dependent, give call buyers the right to purchase the security for the lowest price attained during the option's life. Likewise, put sellers have the right to sell the security for the highest price attained during the option's life. The underlying asset in a look-back option is often a commodity. As with barrier options, the value of a look-back can depend on the frequency with which the asset price is monitored. 


Options can be used for hedging or speculative purposes. Hedgers can use options to protect against price movements in an underlying instrument or interest-rate exposure. Speculators can use options to take positions on the level of market volatility (if delta-hedged with the underlying instrument) or the direction and scope of price movements in the underlying asset. 

The asymmetric payoff profile of an option is a unique feature that makes it an attractive hedging vehicle. For example, an investor with a long position in an underlying asset can buy a put option to offset losses from the long position in the asset if its price falls. In this instance, the investor's position in the asset will be protected at the strike price of the option, and yet the investor will still gain from any rise in the asset's value above the strike price. Of course, this protection against loss combined with the ability to gain from appreciation in the asset's value carries a price-the premium the investor pays for the option. In this sense, the purchase of an option to hedge an underlying exposure is analogous to the purchase of insurance.1 

Options may also be used to gain exposure to a desired market for a limited amount of capital. For instance, by purchasing a call option on a Treasury security, a portfolio manager can create a leveraged position on a Treasury security with limited downside. For the cost of the option premium, the portfolio manager can obtain upside exposure to a movement in Treasury rates on the magnitude of the full underlying amount. 

Many banks sell interest-rate caps and floors to customers. Banks also frequently use caps and floors to manage their assets and liabilities. Caps and floors are essentially OTC interest-rate options customized for a borrower or lender. Most caps and floors reference LIBOR (and thus are effectively LIBOR options). Eurodollar options are essentially the exchange-traded equivalent of caps and floors. 

A cap, which is written independent of a borrowing arrangement, acts as an insurance policy by capping the borrower's exposure (for a fee, the option premium) to higher borrowing costs if interest rates rise. This is equivalent to the cap writer selling the purchaser a call on interest rates. Above the cap rate, the purchaser is entitled to remuneration from the cap writer for the difference between the higher market rate and the cap rate. Often caps have a sequence of (three-month) expiration dates. Each of these three-month pieces is known as a caplet. A bank looking to ensure that it does not pay above a specified rate on its LIBOR-based liabilities can achieve this objective by purchasing an interest-rate cap. 

A floor is the opposite of a cap and sets a minimum level on interest rates. Thus, it is like a put option on interest rates. If interest rates fall below the floor rate, the purchaser is entitled to remuneration from the floor writer for the difference between the lower market rate and the floor rate. An asset manager with floating-rate LIBOR assets can purchase a floor to ensure that his or her return on the asset does not fall below the level of the floor. 

An option strategy consisting of selling a floor and buying a cap is referred to as an interest-rate collar. Collars specify both the upper and lower limits for the rate that will be charged. It is usually constructed so that the price of the cap equals the price of the floor, making the net cost of the collar zero. Caps and floors are also linked to other indexes such as constant maturity Treasury rates (CMT), commercial paper, prime, 11th District Cost of Funds Index (COFI), and Treasury bills. 

1. Note that the investor's position in this example, a long position in the underlying asset and a purchased put option, has exactly the same payoff profile as a position consisting of only a purchased call option. This example illustrates the ability to combine options and the underlying asset in combinations that can replicate practically any desired payoff profile. For example, a purchased call combined with a written put, both with the same exercise price, have the same exposure profile as a long position in the underlying asset.


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