Question

1. An agreement to lease a car can be thought of as a set of derivative contracts. Describe them.

2. What are the risks and rewards of writing and buying options? Are there any circumstances under which you would get involved? Why or why not?

3. What kind of an option should you purchase if you anticipate selling $1 million of Treasury bonds in one year's time and wish to hedge against the risk of interest rates rising?

Answer 1

Answer 1:
When someone leases a car, he or she agrees to make a series of fixed monthly payments; this is like a forward contract. At the end of the lease, the lessee can purchase the car; this is like an option.

Answer 2:
Reducing Your Risk (Reward)
For many investors, options are useful tools of risk management. They act as insurance policies against a drop in stock prices. For example, if an investor is concerned that the price of their shares in LMN Corporation is about to drop, they can purchase puts that give the right to sell the stock at the strike price, no matter how low the market price drops before expiration. At the cost of the option's premium, the investor has insured themselves against losses below the strike price. This type of option practice is also known as hedging.

Risking Your Principal(Risk)
Like other securities including stocks, bonds and mutual funds, options carry no guarantees. Be aware that it's possible to lose the entire principal invested, and sometimes more. As an options holder, you risk the entire amount of the premium you pay.

I would get involved in options trading because options can be combined with each other or other investments to further change the associated risks and returns.
For example, an investor might purchase a share of a stock and also a put option on this stock in a strategy known as a protective put. As the name implies, a protective put is a strategy used to “hedge” or protect against the risk of the stock price declining substantially.

Answer 3:
You could purchase a put option that gives you (as the holder) the right but not the obligation to sell the bonds as a price determined today.
Therefore, if interest rates rise and so the price of the bonds falls, you can exercise the option and sell the bonds at the pre-determined price. If, on the other hand, interest rates fall, you can let the option expire and enjoy the benefits of the increase in the price of the bonds.