We now look at the different types of financial options available. They are categorized in terms of the underlying instrument.
These are options (sometimes called equity options) on individual stocks and are popular in the market.
These are options on stock indices, such as the S&P 500 Index, which are for cash settlement (based on a multiplier times the index level).
Bond options are not popular with the retail investor and most of the trading is between institutions in the over-the-counter market. They can be for actual delivery or for cash settlement and are based on a notional principal which is quoted in terms of the face value of the bond.
Interest rate options
We will consider options on LIBOR as an example of interest rate options. Note that there is not an underlying financial instrument but an interest rate that is used to calculate the payoff.
In the case of FRAs the payoff is based on the discounted spot rate of a LIBOR payment. Interest rate options are options where the underlying asset is an interest rate so rather than an exercise price we have an exercise rate or strike rate. An FRA is a commitment to make and receive an interest rate payment at a later date and the payment is made immediately the contract expires. An interest rate option is the right to make one interest payment and receive another.
An interest rate call is an option where the holder has the right to make a known interest rate payment and receive an unknown payment. An interest rate put is an option where the holder has the right to make an unknown interest rate payment and receive another known payment.
Interest rate options and FRAs have a notional principal. The options are usually European style and settle for cash. They are often dealt in by the same dealers that make prices in FRAs.
When interest rate options are being used for hedging, for example to hedge the risk on a floating rate loan, then the buyer is purchasing a series of interest rate options. This series of call options is called an interest rate cap, or a cap. A series of interest rate put options is called an interest rate floor, or floor. An interest rate cap is defined as a series of call options on an interest rate, with each option expiring at the date on which the rate on the floating rate loan will be reset; each option has the same exercise rate. Each call option is a caplet. Similarly each component of an interest rate floor is a floorlet. The price of the interest rate cap or floor is just the sum of the constituent options.
An interest rate collar is a combination of a long cap and short floor or vice versa.
A currency option gives the holder the right to buy or sell an underlying currency at a fixed exercise rate, which is an exchange rate.
Options on futures
This is an option where the underlying is a futures contract; a call option gives the holder the right to go long of the futures at a fixed price and a put option the right to go short. The fixed futures price is the exercise price. There are arbitrage opportunities and in some cases the options are essentially an option on the spot price of the underlying asset (when the options and futures expire on the same date).
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