Options I

Abstract

As a risk management tool, options allow banks and corporates to hedge market exposure but also to gain from upside moves in the market; this makes them unique amongst hedging instruments. Options have special characteristics that make them stand apart from other classes of derivatives. As they confer a right to conduct a certain transaction, but not an obligation, their payoff profile is different from other financial assets, both cash and off-balance sheet (OBS). This makes an option more of an insurance policy rather than a pure hedging instrument, as the person who has purchased the option for hedging purposes need only exercise it if required. The price of the option is in effect the insurance premium that has been paid for peace of mind.