A Chooser Option or a Straddle: Valuation and Efficiency Analysis
Introduction
The necessity in new efficient financial instruments has risen dramatically for the last two decades, due to a sharp increase in the complexity of financial markets and the uncertainty to which the market participants face. Derivatives play an important role in the world’s economy nowadays, allowing various investment and hedging opportunities. The proper use of financial derivatives such as options increases the potential returns and at the same time has an opposite effect on the level of the exposed risk. However, in terms of trading opportunities, an option alone cannot offer such great possibilities. For example, plain vanilla European call or put options can generate profit for their holders only in the case when the underlying stock price at the expiration date is above or below certain determined price (strike price) respectively. Thus, often investors stack several options together to form a trading strategy that would better satisfy their needs or feelings about the future movements of the market. Multiple strategies involving options exist today, but in the proposed study the attention will be paid to the strategies which presuppose the increase in the future volatility of the underlying asset such as straddle or strangle. The emphasis is made on this type of strategies since the volatility, which dramatically increased after the financial crisis of the end 2000-s, still has not
The 1944 Crime and Drama film, Double Indemnity, directed by Billy Wilder, showed the love story between an insurance representative and one of his client's wife who plotted to commit insurance fraud on his company, Pacific All Risk Insurance CO., in order to be together. The insurance representative, Walter Neff, met Phyllis Dietrichson during one of his visit to Mr. Dietrichson's home. Phyllis inevitably becomes interested in acquiring accidental insurances for her husband which includes double indemnity. Walter begins to suspect her intentions but shortly later, they began to have an affair and Phyllis proposes to kill her husband in order to receive the money. Walter agrees to this proposal and plans the perfect death so his company would
Options strategies share a similar defect with forward sales. That is the weakness of getting the maximum profits that are available when the price goes up or indeed has the potential to rise. “By adjusting the exercise prices and ratios of puts and calls, American Barrick could determine the degree to which it chose to participate in gold price sales”. However, options contracts are usually not longer than 5 years and only contracts with maturities under 2 years have high liquidity. Thus, the time spread of it is far shorter than the 20 years of expected production currently in reserve. Taking these factors into consideration, we think options contracts are good for American Barrick to hedge risk in short-term period.
When Nick Leeson was being promoted on the Singapore branch of the Barings bank, the strategy of the bank was to reduce the risk exposure by using a combination of one short straddle (combination of put / call) and for one long future. Since Nick Leeson used to be a specialist on Future contracts on Nikkei 225 and Japanese 10 years bond and was sure this market would arise.
Second City Options (SCO) is a small firm that specializes in option trading. Employing 35 people, SCO is located on LaSalle Street in the Chicago financial district. It is a member firm of the Chicago Board Options Exchange (CBOE), where it trades options on stocks and stock indices. It is also a member firm of the Chicago Mercantile Exchange Group (CME Group), where it trades options on futures and the underlying futures contracts.
The starting point of any foreign exchange risk management plan is to identify the exchange exposure faced. In controlling the foreign exchange risk, currency options have attained acceptance as very helpful tools due to their exclusive nature. They are very critical and convey a much wider range of hedging alternatives. Call options provide the right to the buyer to purchase the
LTCM’s board of directors included many geniuses in from the financial world, who collectively created complex models allowed them to calculate risk of securities much more accurately than others. LTCM’s trading strategy was featured by the divergence in price between long-term U.S. Treasury bonds. It shorted the more expensive “on-the-run” bond and purchased the “off-the-run” security at the same time to exploit the price divergence. In order
Analyze the derivatives market and determine the use of derivatives to efficiently manage investment risks in an investment portfolio.
The learning objectives for students in this course are: (l) improve your understanding of financial securities and markets, (2) develop the ability to analyze investment companies, common stocks, and bonds for investment decisions, (3) understand how options are
In order to set the option pricing model, other basic assumptions have been used such as the market is efficient and frictionless which means that people cannot predict with consistency the direction of stocks in the financial market; no tax or transaction costs occur and there are no legal restrictions on trading in the options and in the underlying asset, or on short-selling the asset (Data and Mathews, 2004; Jiang, 2005). The BSM model also assumes that the market is arbitrage free which indicates there
Then, we took into consideration only a fluctuation of the exchange rate. The scenarios that we analyzed covers different positions of the dollar against the euro: weak dollar (USD 1,48/EUR), stable dollar (USD 1,22/EUR) and strong dollar (USD 1,01/EUR). Different coverage of costs with hedging was also introduced in the analysis. The three main policies are of not hedging, 100% hedging with forward contracts and 100% hedging with options.
Established in January 1999, Pine Street Capital (PSC) was a market-neutral hedge fund that specialized in the technology field, facing market risk and trying to decide whether and which way to use in order to hedge equity market risk. They choose technology sector because the partners of PSC felt that they have enough ability to evaluate this sector and specially be good at picking out-performing stock. Short-selling of NASDAQ and options hedging strategy are the two major hedging choices for PSC. Either strategy has its own advantages in different economic periods and conditions. The fund has just through one of the most volatile periods in NASDAQ 's history, and it was trying to decide whether it should continue its risk management
Nestlé S.A. is a Swiss company and owns a prestigious position being the world’s leading nutrition, health and wellness group (Nestlé, 2016). According to its annual report (2015), this company is exposed to many risks caused by movements in foreign currency exchange rates, interest rate and market prices. The foreign exchange risk comes from transactions and translations of foreign operations in Swiss Francs (CHF). The interest rate risk faces the borrowings at fixed and variable rates. The market price risk comes from commodity price and equity price. The former risk arises from world commodity market for the supplies of coffee, cocoa beans, sugar and others. The later risk arises from the fluctuations of the prices of investments held. (Nestle annual reports, 2015). Thus, financial derivatives instruments are used by this multinational corporation in order to hedge these risks.
When Nick Leeson was being promoted on the Singapore branch of the Barings bank, the strategy of the bank was to reduce the risk exposure by using a combination of one short straddle (combination of put / call) and for one long future. Since Nick Leeson used to be a specialist on Future contracts on Nikkei 225 and Japanese 10 years bond and was sure this market would arise.
Ever since Ross (1976) proposed the Arbitrage Pricing Theory (APT) as an alternative to the capital pricing model, many economists and investors have applied APT across different markets. Whereas the traditional capital pricing model explained asset returns with one beta, sensitivity to the market return, APT decomposes the return with a multiple number of factors. This idea became particularly popular for investors who aim to gain systematic risk other than market risk. However, the model specification aspect has been challenging to many practitioners as the theory does not require any specific sets of variables to be used (Azeez 2006).
Among the most fundamental risks, associated with exchange-traded derivatives, is variable degree of risk. According to Ernst, Koziol, & Schweizer (2011), the transactions in