GLOSSARY

The risk run by a firm that its internal practices, policies and systems are no trigorous or sophisticated enough to cope with untoward market conditions or human or technological errors. Although operational risk is not as easy to identifyor quantify as market or credit risk, it has been implicated as a major factor in many of the highly-publicised derivatives losses of recent years. Sources of operational risk include: failure to correctly measure or report risk; lack of controls to prevent unauthorised or inappropriate transactions being made(the so-called ‘rogue trader’ syndrome); and lack of understanding or awareness among key staff.

A contract that gives the purchaser the right, but not the obligation, to buy or sell an underlying at a certain price (the exercise, or strike price) on or before an agreed date (the exercise period). For this right, the purchaser pays a premium to the seller. The seller (writer) of an option has a duty to buy or sell at the strike price, should the purchaser exercise his right. With European-style options, purchasers may take delivery of the underlying only at the end of the option’slife. American-style options may be  exercised, for immediate delivery, at anytime over the life of the option. Holders of semi-American-style or Bermudan options may be exercised on specified dates – typically on a monthly or quarterly basis.

Options can be bought on commodities, stocks, stock indexes,interest rates, bonds, currencies, etc. The trading terminology, though, may change according to the product. In most cases, the right to buy the underlying is known as a call, and the right to sell, a put. Options are traded on formal exchanges and in over-the-counter (OTC)markets.

The exchanges, such as the HongKong Stock Exchange, the SIMEX, or the ASX provide primarily standardised options; the OTC markets are able to provide tailored products to fit specific requirements. The choice between OTC and exchange-traded options will depend on the degree of tailoring required, the relative liquidity of both markets (this varies greatly according tothe underlying) and credit concerns.Pricing models for simple or vanilla options have five major inputs: the option’s exercise or strike price; the time to expiration; the price of the underlying instrument; the risk-free interest rate on the underlying instrument, and the volatility of the underlying instrument. European-style options are usually priced off a closed-form analytical model first published by Fischer Black and Myron Scholes in 1973, which has subsequently been modified to fit different underlying. At maturity, an option’s value will depend on the value of the right to buyor sell a product. If an option is purchased giving the right to buy gold at $375 anounce and at expiration the price is $400,the option is worth $25.

The extent to which an option is inthe-money (how far the strike price isbelow/above the current forward marketprice) is called its intrinsic value. Wherethe strike price is less favourable than themarket price, the option is said to be outof-the-money, and where the two pricesare the same it is at-the-money.At any time before maturity, an option’sprice will be a combination of its intrinsicvalue (which is always either greater than,or equal to, zero) and its time value. Thelatter includes the cost of carry and theprobability that the price of the underlyingwill move into or remain in the money.Options can broadly be used in two ways –for speculation, or for insurance. Theirusefulness, both from a buyer’s and aseller’s point of view, derives from theirpayouts. In contrast to other types ofhedge, options provide insurance againstunfavourable moves in a product’s priceand the opportunity to take advantage offavourable moves. Forwards and futures,for example, require buyers and sellers tolock into one rate.

In return for assumingthis risk, sellers of options receive apremium, effectively a risk-taking fee.The payout of a purchased option meansthat the price risk of an option is limitedto its premium – it is not as exposed toadverse movements as a position inthe underlying. For speculators selling (writing)options, this often means taking a nakedoption position and therefore beingexposed to adverse movements in theunderlying.Hedgers may sell options togarner premium to offset any expectedslight downturn in a market. Since optionpremiums are only a fraction of the costof the underlying product, it is possible toachieve a much greater exposure to pricechanges of the underlying comparedwith a similar investment directly in theproduct – this is called leverage.

A strategy to change the exposure of a portfolio using derivatives, while leaving the securities in the underlying portfolio unchanged. This has the advantage of cost and flexibility, as portfolio managers can adjust portfolio riskmore quickly and cheaply with derivatives than by liquidating portfolio holdings. Another reason might be tactical – the adjustment may only be desired for a brief period of perceived market threat. A third reason might be to transform a portfolio risk; an international fund manager may wish to segregate the currency aspect of a portfolio and can do so with a currency overlay programme.