Risk management - hedging.
A derivative instrument or contract is one whose value and other characteristics are derived from those of another asset or instrument (sometimes known as the Underlying Asset).
Derivative instruments are widely used by non-financial corporates for hedging purposes.
A share option is a type of derivative contract, allowing the holder to buy shares at a certain predetermined strike price.
The value of the share option derives from the current price of the related underlying share, relative to the option strike price.
For instance, say we hold a call option to buy shares at a strike price of $50, and the option is very close to its expiry date.
If the shares are trading at $90, our option to buy at $50 is valuable.
The option holder could exercise their option, paying $50 per share, and then sell the shares for $90 each, making a profit of $40 per share.
So the option itself is valuable.
We could sell the option for - roughly - $40 (per share).
On the other hand, if the share price were only $20, it wouldn't be rational to exercise an option to buy shares for $50.
It would be irrational to do that, because the shares are cheaper to buy in the market for $20 each.
Accordingly, the option isn't valuable at present.
The value of the option is being driven by - among other things - the share price.
- Call option
- Commodity risk
- Credit support annex
- Embedded derivative
- Expiry date
- Fixing instrument
- Forward rate agreement
- Hedge fund
- Interest rate derivative
- Interest rate swap
- ISDA Master Agreement
- Mark to market
- Notional principal
- Potential Future Exposure
- Replacement cost
- Risk management
- Strike price
- Tracker fund
- Underlying asset
- Underlying price