As we did with futures markets, we conclude the series of posts by looking at the important role options markets play in the financial system. We noted that derivative markets provide price discovery and risk management, make the markets for the underlying assets more efficient, and permit trading at low transaction costs. These features are also associated with options markets. Yet, options offer further advantages that some other derivatives do not offer.
For example, forward and futures contracts have bidirectional payoffs. They have the potential for a substantial gain in one direction and a substantial loss in the other direction. The advantage of taking such a position lies in the fact that one need pay no cash up front. In contrast, options offer the feature that, if one is willing to pay cash up front, one can limit the loss in a given direction. In other words, options have unidirectional payoffs. This feature can be attractive to the holder of an option. To the writer, options offer the opportunity to be paid cash up front for a willingness to assume the risk of the unidirectional payoff. An option writer can assume the risk of potentially a large loss unmatched by the potential for a large gain. In fact, the potential gain is small. But for this risk, the option writer receives money up front.
Options also offer excellent devices for managing the risk of various exposures. An obvious one is the protective put, which we saw earlier and which can protect a position against loss by paying off when the value of the underlying is down.
Recall that futures contracts offer price discovery, the revelation of the prices at which investors will contract today for transactions to take place later. Options, on the other hand, provide volatility discovery. Through the implied volatility, investors can determine the market’s assessment of how volatile it believes the underlying asset is. This valuable information can be difficult to obtain from any other source.
Futures offer advantages over forwards, in that futures are standardized, tend to be actively traded in a secondary market, and are protected by the exchange’s clearinghouse against credit risk. Although some options, such as interest rate options, are available only in over-the-counterforms, many options exist in both over-the-counter and exchange-listed forms. Hence, one can often customize an option if necessary or trade it on an exchange.
Tags: cash, derivative market, derivatives, financial systems, futures markets, Option markets