iii) Every investor tries to reduce the risk associated with its portfolio. If the investor is willing to accept 10% of risk as shown in figure 1 it is difficult to get good results. As the risk is high and return is also high, this position becomes more sensitive to the market fluctuations. At this position a slight change in the market will affect the portfolio more. Investors can go for the risk free return but it is usually unrealistic as allowances for the differences in borrowing makes the model more complicated. Ans 2a In US-style option, the buyer has the right to exercise at any time before the expiry of the option and counterparty must follow in the part of the buyer of option for execution.
Counterparty doesn’t have any right to deny the execution of the option before the expiry of the risk associated with the counterparty. The reason for counterparty risk is basically due to the credit risk of the option writer (Klein and Yang 2010, p. 1) Ans 2b The biggest advantage of using options contracts is that it gives stability and security to the investors and the traders.
This makes them contribute more in the market operations and also greatly contribute to the economy. It reduces the risks involved and also increase investors confidence thus they buy more options the agents sells. Since unsystematic risk is normally unverifiable, the risk occurs due to external factors which are unpredictable. In order to minimize such use of options, we can reduce such kind of risk and for this purpose you may be required to pay premium to secure your investment. Investors buy these options only to minimize risk and secure their investment.
In this kind of options the buyer makes contracts aimed at execution on a fixed price rate for a specific period. Ans 2c(i) In this article, john Fletcher is going to write a call option and get premium to make his side secure. He is the counterparty in this option’s strategy where he will earn from the dividends and return gained from an increase in the share price. Ans 2c(ii) Since you want to earn some returns in the sale you give them the right to sell them on your behalf to the highest bidder.
Once you write put option, you will get premium from the option buyer. When buyer buys put option in anticipation that the market will go down, and market conditions are not supporting these shares, and market in not stable for share trading. These unstable conditions of the market support the option buyer, but for you as a writer of option a rising stock market can give you more income.
REFERENCESKlein, P. and Yang, J. 2010, “Counterparty Credit Risk and American Options”, Burnaby, B.C. viewed on 18 July, 2011.