The Mathematics of Financial Modelingand Investment Management

2-Financial Markets Page 64 Wednesday, February 4, 2004 1:15 PM

64 The Mathematics of Financial Modeling and Investment Management

Futures provide another market that investors can use to alter their

risk exposure to an asset when new information is acquired. An investor

will transact in the market that is the more efficient to use in order to

achieve the objective. The factors to consider are liquidity, transaction

costs, taxes, and leverage advantages of the futures contract. The mar-

ket that investors feel is the one that is more efficient to use to achieve

their investment objective should be the one where prices will be estab-

lished that reflect the new economic information. That is, this will be

the market where price discovery takes place. Price information is then

transmitted to the other market. It is in the futures market that it is eas-

ier and less costly to alter a portfolio position. Therefore, it is the

futures market that will be the market of choice and will serve as the

price discovery market. It is in the futures market that investors send a

collective message about how any new information is expected to

impact the cash market.

How is this message sent to the cash market? We know that the

futures price and the cash market price are tied together by the cost of

carry. If the futures price deviates from the cash market price by more

than the cost of carry, arbitrageurs (in attempting to obtain arbitrage

profits) would pursue a strategy to bring them back into line. Arbitrage

brings the cash market price into line with the futures price. It is this

mechanism that assures that the cash market price will reflect the infor-

mation that has been collected in the futures market.

OPTIONS

An option is a contract in which the writer of the option grants the buyer

of the option the right, but not the obligation, to purchase from or sell to

the writer something at a specified price within a specified period of time

(or at a specified date). The writer, also referred to as the seller, grants

this right to the buyer in exchange for a certain sum of money, which is

called the option price or option premium. The price at which the asset

may be bought or sold is called the exercise or strike price. The date after

which an option is void is called the expiration date.

When an option grants the buyer the right to purchase the desig-

nated instrument from the writer (seller), it is referred to as a call

option, or call. When the option buyer has the right to sell the desig-

nated instrument to the writer, the option is called a put option, or put.

Buying calls or selling puts allows the investor to gain if the price of the

underlying asset rises. Selling calls and buying puts allows the investor

to gain if the price of the underlying asset falls.