25-28 Options Options Contract – Right to buy (call option) or sell (put option) an instrument at the exercise (strike) price up until expiration date (American) or on expiration date (European). Options are available on a number of financial instruments, including individual stocks, stock indexes, etc.
25-29 Options Hedging with Options – Buy same number of put option contracts as would sell of futures – Disadvantage: pay premium – Advantage: protected if i increases and price declines if i decreases and price increases – no losses on option
Interest-Rate Swap Contract Example Midwest Savings Bank wishes to hedge rate changes by entering into variable-rate contracts. Friendly Finance Company wishes to hedge some of its variable-rate debt with some fixed- rate debt. Notional principle of $1 million Term of 10 years Midwest SB swaps 7% payment for T-bill + 1% from Friendly Finance Company.