Financial Markets & Institutions (MindTap Course List) by Jeff Madura

Author:Jeff Madura [Madura, Jeff]
Language: eng
Format: epub
Publisher: Cengage Learning
Published: 2020-02-04T06:00:00+00:00

Chapter 14: Option Markets 355

Any firms that use futures or other derivative instruments can draw a few obvious lessons from the Barings collapse. First, firms should closely monitor the trading of derivative contracts by their employees to ensure that derivatives are being used within the firm’s guidelines. Second, firms should separate the reporting function from the trading function so that traders cannot conceal trading losses. Third, when firms receive margin calls on their derivative positions, they should recognize that there may be potential losses on their derivative instruments and should closely evaluate those positions. The Barings case was a wake-up call to many firms, which recognized the need to establish guidelines for their employees who take derivative positions and to monitor the actions of these employees more closely.

14-4 hedging with stock Options

Call and put options on selected stocks and stock indexes are commonly used for hedging against possible stock price movements. Financial institutions such as mutual funds, insurance companies, and pension funds manage large stock portfolios and are the most common users of options for hedging.

14-4a Hedging with Covered Call Options

Call options on a stock can be used to hedge a position in that stock.

ExamplE

Portland Pension Fund owns a substantial amount of Steelco stock. It expects that the stock will perform well in the long run, but it is concerned that the stock may perform poorly over the next few months because of temporary problems Steelco is experiencing. The sale of a call option on Steelco stock can hedge against such a potential loss. This type of option is known as a covered call because the option is covered, or backed, by stocks already owned.

If the market price of Steelco stock rises, the call option will likely be exercised, and Portland will fulfill its obligation by selling its Steelco stock to the purchaser of the call option at the exercise price. Conversely, if the market price of Steelco stock declines, the option will not be exercised. Hence Portland would not have to sell its Steelco stock, and the premium received from selling the call option would represent a gain that could partially offset the decline in the price of the stock. In this case, although the market value of the institution’s stock portfolio is adversely affected, that decline is at least partially offset by the premium received from selling the call option.

Assume that Portland Pension Fund purchased Steelco stock at the market price of $112 per share. To hedge against a temporary decline in Steelco’s stock price, Portland sells call options on Steelco stock with an exercise price of $110 per share for a premium of $5 per share. Exhibit 14.12 shows the net profit achieved by Portland when using covered call writing under several possible scenarios. For comparison purposes, the profit that Portland would earn if it did not use covered call writing but instead sold the stock on the option’s expiration date is also shown (see the diagonal line) for various possible scenarios. The results show how covered

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