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Greeks

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T E C H N I C A L

TECHNICAL

The Greeks are coming
STEVE JAY RELEVANT TO PAPER 3.7

The new Paper 3.7 Syllabus includes far more detail on options than the old Paper 14. This article looks at the areas involved in the ‘scope and benefits of financial engineering’ section of the syllabus. The reference to Greeks will become clear as we proceed. WHAT IS AN OPTION? The definition in finance is quite similar to that in every day language, i.e. an option is the right but not the obligation to perform a certain action. More specifically in finance it means that if we buy a call option we have the right but not the obligation to buy: • a fixed amount; • at a fixed time; • at a fixed price; • of the underlying instrument. On the other hand if we buy a put option we have the right but not the obligation to sell: • a fixed amount; • at a fixed time; • at a fixed price; • of the underlying instrument. TABLE 1: OPTION TERMINOLOGY Call option Put option Exercise price/Strike price In the money Out of the money American Option European Option Premium Traded Option Over the counter option

Let us commence with a summary of the terminology surrounding options. This is given in Table 1 and many of the terms should be familiar from the foreign exchange and interest rate exposure sections of the syllabus. USES OF OPTIONS Options have two major uses on financial markets, speculation and hedging. Figure 1 gives an example of how speculators can use options to gamble on share price movements. It will be noted that the payoff from the option investment is far more volatile than from the straight share. This is because with the option, Barney is specualting on the movement in the share price rather than the share price itself. He has effectively ‘geared up’ his investment. This is a very high-risk strategy and Barney could quite easily lose all of his money. Figure 2 gives a

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