FINM7006 Chap.10 Options and Financial Risk Management
Options and Financial Risk Management
Options add asymmetric protection. A call holder can buy at the strike, while a put holder can sell, and either holder can walk away when exercise is unattractive. The premium pays for that flexibility. This chapter separates payoff from profit, locates break-even without confusing it with exercise, and chooses calls or puts from the underlying exposure.
It closes by matching strike, quantity, maturity and residual risk to the hedge objective.
What this chapter covers
- 01
Call and put exercise rights
- 02
Long and short option positions
- 03
Expiry payoff versus profit
- 04
Intrinsic value and break-even
- 05
Protective puts and purchase calls
- 06
Strike, premium and residual risk
Worked example · free
Compare call and put profit around one strike
- +1Call payoff: max($62 - $50, 0) = $12.
- +1Call profit: $12 - $3 premium = $9.
- +1Put payoff: max($50 - $62, 0) = $0.
- +1Put profit: $0 - $2 premium = -$2.
Key terms
- Call option
- A call option gives its holder the right to buy an underlying item at the strike price.
- Put option
- A put option gives its holder the right to sell an underlying item at the strike price.
- Strike price
- Strike price is the contractual price at which an option holder may exercise.
- Intrinsic value
- Intrinsic value is an option's immediate exercise payoff before the premium is considered.
Options and Financial Risk Management FAQ
What is the difference between option payoff and profit?
Payoff depends on expiry spot and strike. Profit also includes the premium paid or received and any other stated costs. A long option can have zero payoff and still lose money because its premium is unrecovered. Calculate payoff first, then bring in premium once with the correct sign.
How do I choose between a call and a put for hedging?
Start with the unhedged adverse move. A future buyer fears a rise and can buy a call to set a ceiling. An owner or future seller fears a fall and can buy a put to set a floor. The holder keeps favourable price movement but pays a premium for that flexibility.
Does in the money mean the option trade is profitable?
No. In the money means immediate exercise produces positive intrinsic value. The value may still be smaller than the premium, leaving a loss. For a long call, profit break-even at expiry is strike plus premium; for a long put, it is strike minus premium, before any other costs.
Exam move
Draw long call and long put payoffs with the strike marked, then reverse them for short positions. Shift holder payoff by premium to obtain profit and label break-even separately from exercise. Build hedge choices from the physical exposure: future buyer, future seller or existing owner.
For each recommendation, state what is locked, floored or capped, how quantity and maturity match, what premium or margin is required and which basis or timing risk remains. Build every option diagram from the holder's right. A call holder may buy at the strike and a put holder may sell at the strike.
Write the max expression, calculate intrinsic payoff on both sides of the strike, and only then reflect the line for the writer. Keep payoff at expiry separate from profit. The premium shifts the holder's result downward and the writer's upward; if financing of the premium matters, use the time convention stated in the question.
Mark the exercise boundary at the strike and the break-even at strike plus call premium or strike minus put premium. Explain the region where exercise is rational but the original premium has not yet been recovered. Practise combined positions by adding legs point by point. For a protective put, combine a held asset with a long put and identify the floor net of premium.
For a covered call, combine the asset with a written call and identify the capped upside and premium income. Do not describe either as free protection.
Translate risk-management needs before choosing the instrument: a future buyer may use a call to cap purchase cost while preserving cheaper spot prices; an existing owner may use a put to floor sale value while retaining upside; a forward may be preferable when a fixed outcome is wanted and symmetric commitment is acceptable.
Match quantity, strike and expiry to the exposure, then list residual basis, timing, liquidity and counterparty risks. In final preparation, draw all four basic payoff shapes from memory and label slope, strike, maximum holder loss and writer exposure. Follow with one numerical profit table at three spot prices and one recommendation case.
Award interpretation marks only when the answer distinguishes right from obligation, payoff from profit, exercise from break-even, and price insurance from price locking. Rework any confused pair using a fresh diagram rather than memorising the previous numbers.
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