Characterization of options

Abstract

The 1970s have witnessed a rapid expansion in the trading of options. In April 1973 trading commenced on the Chicago Board Options Exchange. It has been followed by the opening of additional facilities on the American Stock Exchange, Pacific Stock Exchange, Philadelphia-Baltimore--Washington Exchange, and others: This reflects the growing interest of investors and portfolio managers in this investment medium; and as might have been expected, the subject has also attracted the attention of the academic community. The latter find the characteristics of options a convenient vehicle to explain the risk-return relationship in the market for various financial assets. The reemergence of this relatively complex investment medium 2 constitutes a major challenge to financial managers who often find the theoretical exposition relating to options somewhat less than transparent. The purpose of this paper, whose primary emphasis is pedagogical, is twofold. Firstly, by clearly defining the significant characteristics of an option contract, much of the confusion regarding the interpretation of the economic role of option trading in an organized security market can be eliminated. To this end a call option will be shown to contain elements of both leverage and insurance) Secondly, it will be demonstrated that the above analysis can be extended to additional financial assets, e.g. warrants, bank deposit insurance, pension obligations, etc. This will be accomplished by showing that such assets can be analyzed in terms of the basic elements of option contracts, i.e. insurance and leverage. The recent financial literature is surveyed