Index options

Jun 20
2009
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Stock market indices are well known, not only in the investment community but also among many individuals who are not even directly investing in the market. Because a stock index is just an artificial portfolio of stocks, it is reasonable to expect that one could create an option on a stock index. Indeed, we have already covered forward and futures contracts on stock indices; options are no more difficult in structure.
For example, consider options on the S&P 500 Index, which trade on the Chicago Board Options Exchange and have a designated index contract multiplier of 250. On 13 June of a given year, the S&P 500 closed at 1241.60. A call option with an exercise price of $1,250 expiring on 20 July was selling for $28. The option is European style and settles in cash. The underlying, the S&P 500, is treated as though it were a share of stock worth $1,241.60, which can be bought, using the call option, for $1,250 on 20 July. At expiration, if the option is in-the-money, the buyer exercises it and the writer pays the buyer the $250 contract multiplier times the difference between the index value at expiration and $1,250.
In the United States, there are also options on the Dow Jones Industrial Average, the Nasdaq, and various other indices. There are nearly always options on the best-known stock indices in most countries.

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Over-the-counter option markets

May 31
2009
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In the United States, customized over-the-counter options markets were in existence in the early part of the 20th century and lasted well into the 1970s. An organization called the Put and Call Brokers and Dealers Association consisted of a group of firms that served as brokers and dealers. As brokers, they attempted to match buyers of options with sellers, thereby earning a commission. As dealers, they offered to take either side of the option transaction, usually laying off (hedging) the risk in another transaction. Most of these transactions were retail, meaning that the general public were their customers.
The creation of the Chicago Board Options Exchange was a revolutionary event, but it effectively killed the Put and Call Brokers and Dealers Association. Subsequently, the increasing use of swaps facilitated a rebirth of the customized over-the-counter options market. Currency options, a natural extension to currency swaps, were in much demand. Later, interest rate options emerged as a natural outgrowth of interest rate swaps. Soon bond, equity, and index options were trading in a vibrant over-the-counter market. In contrast to the previous over-the-counter options market, however, the current one emerged as a largely wholesale market. Transactions are usually made with institutions and corporations and are rarely conducted directly with individuals. This market is much like the forward market described in earlier posts, with dealers offering to take either the long or short position in options and hedging that risk with transactions in other options or derivatives. There are no guarantees that the seller will perform; hence, the buyer faces credit risk. As such, option buyers must scrutinize sellers’ credit risk and may require some risk reduction measures, such as collateral.
As previously noted, customized options have all of their terms-such as price, exercise price, time to expiration, identification of the underlying, settlement or delivery terms, size of the contract, and so on–determined by the two parties.
Like forward markets, over-the-counter options markets are essentially unregulated. In most countries, participating firms, such as banks and securities firms, are regulated by the appropriate authorities but there is usually no particular regulatory body for the over- the-counter options markets. In some countries, however, there are regulatory bodies for these markets.

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