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Financial options

Since time immemorial, man has made attempts to engage in the exchange of goods and services with his fellow men . Even where batter trade was used, the art of buying and selling in a market setup were dominantly employed. But as a result of market globalization, it became imperative that people identify a common market where both buyers and sellers can place their orders and transact business, hence the stock exchange. Transactions in the stock market involve trading in options.

According to Hawkins (2010), a call option refers to an agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period, while a put option on the other hand refers to an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time.

A call option’s exercise value is the price at which the underlying security (a stock, bond, commodity, or other instrument) can be purchased. Since the call’s exercise price is the key to profiting from options, there must always be a difference between the exercise value and the actual market value of a call. The greater the difference, the more the amount of money required to purchase the call.

A risk-free portfolio can be made through employing investment strategies that might be risky, but which will eventually make the portfolio safer. These strategies may include hedging strategies, buying insurance with options, using low-correlation assets, reducing benchmark or active risk and understanding one’s real risks(Hawkins,2010). Black-Scholes Option Pricing Model is a mathematical method of calculating the value of a stock option that was developed by Fischer Black and Myron Scholes in 1973.

It uses the following assumptions; the stock pays no dividends during the options life, European exercise terms are used, markets are efficient, no commissions are charged, interest rates remain constant and known and returns are abnormally distributed (Rabush’s Study of Option Pricing Models, n. d). References Rabush. K. (n. d). A Study of Option Pricing Models. Retrieved July 20th, 2010, from http://hilltop. bradley. edu/~arr/bsm/model. html Hawkins. K. (2010). Make Your Portfolio Safer With Risky Investments. Retrieved July 20th, 2010, from http://www. investopedia. com/articles/financial-theory/08/reduce-risk. asp

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