Question

In: Finance

Options as Insurance Instruments Clearly, given that options allow their owners to take certain financial actions...

Options as Insurance Instruments

Clearly, given that options allow their owners to take certain financial actions in favor of their portfolio objectives, they can be thought of as financial insurance: if the price of the underlying assets moves in an unfavorable direction, the option can be exercised to restrict the losses to be experienced. The value of this form of insurance is affected by both the dynamics of the underlying assets and the type of option used. The overall insurance value of an option is defined by no-arbitrage restrictions on option prices and largely by the exercise time of the option.

You will explore the concept of options as insurance for a financial investment. To Prepare: Review this week’s Learning Resources, as well as other resources you may access and the Internet. Consider the following: In what way(s) are calls a form of financial insurance, as opposed to puts? What information about options and/or their underlying assets would users of options need to determine their insurance value?

Post by Day 3 a 4- to an 8-paragraph analysis of the insurance value of options. Make sure to include responses to the following specific questions:

#1 How is the insurance value of an option determined by the difference between the cost of an option and the cost of a synthetic portfolio? Provide a numerical example.

#2 What factors can make the insurance value of an American option be much greater than that of its European equivalent?

#3 Is there any information that can be derived from the markets on what the insurance value of options is for their actual users (in other words, can we tell who hedges and who speculates with options)? C

learly address each of the questions with 1–3 paragraphs. Make sure you use APA style for your response(s) and properly cite any resources you have used

Solutions

Expert Solution

Options are similar to insurance policies in the following ways:

SR.NO

INSURANCE POLICIES

OPTIONS

1

Insurance policies are bought to protect against unforeseen events

Options are bought to create a hedge against an existing position.

2

Any amount of insurance policies can be purchased

Any amount of options can be purchased

3

With an insurance policy if a claim is not made the policy becomes worthless at the end of its time

Options have a fixed life and expire worthless. This means that whenever one purchases an option he loses the premium if the option is not exercised

4

Pricing of an insurance policy is based on several factors like age, location, sex,etc.

Pricing of an option is based on volatility of the underlying

Options are mainly of two types:

  1. Call options
  2. Put options

A call option gives the buyer the right but not the obligation to purchase the underlying security and is bought when the prices are expected to go up whereas a put option gives the buyer the right but not the obligation to sell the underlying security and is bought when the prices are expected to go down. Thus both call options and put options are very similar as instruments of financial insurance.

The major difference in these two types of options being used as financial insurance is mathematical in nature. When the price rises the increase in price is unlimited and can go to infinity. However when the price falls he decrease in price is limited and will only go up to zero. Thus the gains from a call option are unlimited whereas the gains from a put option are limited.

Another important point worth taking note of is the speed with which prices ascend or desend. Rise in prices are generally steady and structured whereas fall in prices are fast and governed by human emotions.

Hence, we can conclude that call options are a better form of financial insurance as against put options.


Related Solutions

Identify some actions to take to achieve financial goals.
Identify some actions to take to achieve financial goals.
financial derivatives "owners of options have rights and sellers of options have obligation" what does this...
financial derivatives "owners of options have rights and sellers of options have obligation" what does this sentence mean?
Okay, we know entrepreneurs take risks... risks for the sake of profit.  Clearly, business owners do...
Okay, we know entrepreneurs take risks... risks for the sake of profit.  Clearly, business owners do their best to get the best (highest) return on investment.  This comes in the form of profits (money), employee recruiting efforts, employee retention strategies, training/coaching, and overall business development.  All of this requires money and business owners need to decide the most efficient allocations of their financial and human capital resources. Discuss how a business can measure and manage its financial resources.  What are...
a) Discuss what actions the Government and the RBA should take given the information in the...
a) Discuss what actions the Government and the RBA should take given the information in the table. Year Potential GDP Real GDP Inflation 2019 $ 1450 trillion $1600 trillion 5%                                                                                                                                                         b) What could go wrong if the above-discussed policies are implemented?
"The goal of financial management is to take actions which maximize the value of a firm's...
"The goal of financial management is to take actions which maximize the value of a firm's stock. Those actions will eventually appear in the firm's financial statement, so a general understanding of financial statements is very important for the manager." Given the recent failure of many financial institutions, do you believe business leaders really understand and use all of the concepts and principles we teach in accounting, finance, and economics? In addition, do you believe financial managers are truly concerned...
The following information is given about options on the stock of a certain company. S0 =...
The following information is given about options on the stock of a certain company. S0 = 23                   X = 20 rc = 0.09                 T = 0.5 s2 = 0.15 No dividends are expected. 1)What is the value of the call option based on the Black and sholes Merton model? 2) If the Stock is distributing dividends of $0.85 with 12 days ex-dividends day what is the value of the call? 3) what is the Delta of the option, what about...
The buyer of a certain machine is given 2 options to pay it: 1st option is...
The buyer of a certain machine is given 2 options to pay it: 1st option is paying it P2,000 downpayment and P2,000 annually for the next 6 years; 2nd option is to pay it P3,500 downpayment and P2,000 annually for the next 5 years. If the money is worth 12% cpd. annually, which option is better and by how much? Today, a man invested P20,000 for the college education of his 4-year old daughter. If the fund earns 12% cpd....
Consider a typical individual who owns the following financial instruments: A life insurance policy for $340,000;...
Consider a typical individual who owns the following financial instruments: A life insurance policy for $340,000; a certificate of deposit for $85,000; homeowner's and auto insurance policies; $14,000 in a mutual fund, and $230,000 in her pension fund at work. Which of these are instruments used primarily as stores of value and which are being used to transfer risk?
What strategic actions could Mr. Woodman take to reestablish GoPro’s financial and market performance?
What strategic actions could Mr. Woodman take to reestablish GoPro’s financial and market performance?
Problem 1: The following information is given about options on the stock of a certain company:...
Problem 1: The following information is given about options on the stock of a certain company:             S0 = $80, X =$70, r =10% per year (continuously compounded), T = 9 months, s= 0.30 No dividends are expected. One option contract is for 100 shares of the stock. All notations are used in the same way as in the Black-Scholes-Merton Model. What is the European call option price and European put option price, according to the Black-Scholes model? What is...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT