Academic journal article Business: Theory and Practice

Sensitivity of Option contracts/Pasirinkimo Sandoriu Jautrumo Veiksniu Tyrimas

Academic journal article Business: Theory and Practice

Sensitivity of Option contracts/Pasirinkimo Sandoriu Jautrumo Veiksniu Tyrimas

Article excerpt

Introduction

It could be stated that options include some special features that exclude them from other derivative securities. Options as financial means can be used in many possible ways for creating various opportunities for attractive investment. Empirical studies presented in financial literature by foreign and Lithuanian authors (Avellaneda, Laurence 2000; Hull 2000; Friedentag 2000; Rutkauskas 1998; Kancerevycius 2006) illustrate that options incorporate an insurance element not available in any other security and therefore can be used by investors for creating return distributions unobtainable with the strategy of allocating funds between stock portfolios and fixed income securities. Options can be used for speculating on profit, earning income to enhance investment returns and protecting against a temporary decline in the value of stock or other commodity both financial and material.

Still, everyone using option contracts as a hedging mean must understand and evaluate the degree of risk they impose. Sometimes investors do not pay proper attention to the evaluation and management of risky options and their investment strategies, which is the main condition for the successful use of these derivative securities.

Due to the complex valuation of option contracts, the main scientific studies are devoted to analyse separate methods of option pricing (Hull 2000; Jarrow, Rudd 1983; Martin 2001; Kancerevy?ius 2003; Gregoriou 2010; Amaro et al. 2009). A big part of authors (Hull 2000; Bodie, Merton 2000; Haugen 2001; Rutkauskas 1998) are interested in how to manage the risk of value changes in the underlying asset or how to protect against losses in stock or currency markets. Nevertheless, the main condition of the successful use of the analysed derivative securities is the understanding, evaluation and management of risky options. It is important to investors to compare the necessity and possible dangers of using options in order to choose a proper strategy and to manage risk related to this choice.

The purpose of this article is to analyse the main factors in option risk and sensitivity and to explain the possibilities of their management. The object of the article is option sensitivity factors as the measures of their riskiness.

In order to reach the purpose of the article, the following steps are going to be made:

1) to define the main concepts describing the features of options;

2) to analyse factors in option sensitivity and risk;

3) to determine the possibilities of managing factors in option risk.

An analytical systemic analysis of scientific literature and papers produced by foreign and Lithuanian scientists as well as comparative analysis and graphical modelling were used for investigation purposes.

1. The Main Features of Option Contracts

A review of financial literature allows making a conclusion that different authors (Hull 2000; Rutkauskas 1998; Kancerevycius 2006) give almost the same description of option contract emphasising the right to choose. An option is an instrument giving its owner the right but not obligation to buy or sell something at a price fixed in advance. Options are used on a wide range of products starting from raw materials and ending in financial assets, gold or real estate. The article mainly focuses on stock options because these instruments are widely traded as over the counter contracts and appear in exchanges.

Two types of stock options--calls and puts (Whaley 2006) are available. A call option gives the holder the right to buy a specified quantity of stock at the strike price on or before expiration date. The writer of the option, however, has the obligation to sell the underlying asset if the buyer of the call option decides on exercising his right to buy. A put option gives the holder the right to sell the specified quantity of the underlying stock at the strike price on or before expiration date. …

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