THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 401
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CHAPTER 14
Risk Management with Financial Derivatives
369
these contracts. Of course, these losses are offset by unrealized profits in the
rest of the bank s portfolio, but the bank is not allowed to offset these losses in
its accounting statements. So even though the macro hedge is serving its
intended purpose of immunizing the bank s portfolio from interest-rate risk,
the bank would experience large accounting losses when interest rates fall.
Indeed, bank managers have lost their jobs when perfectly sound hedges with
interest-rate futures have led to large accounting losses. Not surprisingly, bank
managers might shrink from using financial futures to conduct macro hedges
for this reason.
Futures options, however, can come to the rescue of the managers of banks
and other financial institutions. Suppose that First Bank conducted the macro
hedge by buying put options instead of selling Canada bond futures. Now if
interest rates fall and bond prices rise well above the exercise price, the bank
will not have large losses on the option contracts because it will just decide not
to exercise its options. The bank will not suffer the accounting problems
produced by hedging with financial futures. Because of the accounting advantages of using futures options to conduct macro hedges, option contracts have
become important to financial institution managers as tools for hedging interestrate risk.
Factors
Affecting the
Prices of
Option
Premiums
There are several interesting facts about how the premiums on option contracts
are priced. The first fact is that when the strike (exercise) price for a contract is
set at a higher level, the premium for the call option is lower and the premium
for the put option is higher. For example, in going from a contract with a strike
price of 110 to one with 115, the premium for the February call option might
fall from 1 39/64 to 1/64, and the premium for the March put option might rise
from 15/64 to 3 28/64.
Our understanding of the profit function for option contracts illustrated in
Figure 14-3 helps explain this fact. As we saw in panel (a), a higher price for the
underlying asset (in this case a Canada bond futures contract) relative to the
option s exercise price results in higher profits on the call (buy) option. Thus the
lower the strike price, the higher the profits on the call option contract and the
greater the premium that investors like Irving are willing to pay. Similarly, we
saw in panel (b) that a higher price for the underlying asset relative to the exercise price lowers profits on the put (sell) option, so that a higher strike price
increases profits and thus causes the premium to increase.
The second thing is that as the period of time over which the option can
be exercised (the term to expiration) gets longer, the premiums for both call
and put options usually rise. For example, at a strike price of 114, the premium on the call option might increase from 1/64 in February to 4/64 in
March and to 7/64 in April. Similarly, the premium on the put option at a strike
price of 111 might increase from 8/64 in February to 32/64 in March and to
1 13/64 in April. The fact that premiums increase with the term to expiration
is also explained by the nonlinear profit function for option contracts. As the
term to expiration lengthens, there is a greater chance that the price of the
underlying asset will be very high or very low by the expiration date. If the
price becomes very high and goes well above the exercise price, the call (buy)
option will yield a high profit, but if the price becomes very low and goes well
