Money, Banking, and International FinanceDid you notice something strange about the call and put options? Investors exercise call and
put options “as opposites” when an investor exercises an option. Furthermore, we switched the
exercise and spot prices in Equations 8 and 10.
Special Derivatives
Several financial institutions offer futures and options that are based on a market index,
such as the Dow Jones Industrial Average and S&P 500. For example, the Chicago Board of
Options Exchange (CBOE) offers options on the Dow Jones Industrial Average, which it calls
DJX. Technically, the derivatives are not tied to a commodity. A financial company does not
invest in a mutual fund that mirrors a stock index. For example, a fund manager could buy 1,000
shares each of every company listed in the Dow Jones Industrial Average and let investors buy
into the fund. Instead, the financial companies base the stock market index on a computed stock
market index and settle accounts in cash. Since no commodities are exchanged, the financial
companies offer call and put options on the stock market indices. These companies cannot offer
futures and forwards because buyers and sellers cannot trade a commodity.
Issuers of index derivatives could suffer large losses to rapid market changes. For example,
one investor, Nick Leeson, bankrupted Barings, P.L.C. Nick Lesson observed the stocks on the
Tokyo stock market fluctuated over a narrow range. The Nikkei stock index fluctuated around
20,000 points in 1995. Nick Leeson used a straddle and issued an equal number of call and put
options with identical maturities for the Nikkei stock index. Hence, the investors rarely
exercised the options because the stock prices fluctuated over a narrow range. Thus, the option
premiums became pure profits to Barings. As profits were soaring, the top management at
Barings let Nick Leeson continue his speculation. Then an earthquake struck Kobe, Japan, and
both the stock prices and Nikkei average fell rapidly on the Tokyo stock exchange. Leeson
speculated the stock prices would increase and bought futures contracts to protect his position.
Subsequently, the stock prices continued plummeting, resulting in a $1.4 billion loss for
Barings. Unfortunately, Barings was forced to settle with option holders who bet the Nikkei
average would fall.
The Chicago Board of Options Exchange (CBOE) offers put and call options for the
Volatility Index (VIX), calculated from Standard & Poor's (S&P) 500-stock index. The VIX
represents a measure of risk and volatility, otherwise known as the investor's fear gauge. Similar
to a stock index derivative, the options are not tied to an asset or commodity. On maturity, a
holder receives payment as the CBOE settles the obligation in cash. Furthermore, the VIX
suffers from exposure if the VIX increases or decreases dramatically. Then CBOE could suffer
large losses as it pays out for exercised options.
One must be careful with the meaning of the VIX number. For example, if the VIX equals
20, subsequently, the investors expect the S&P 500-stock index to swing by 20% over the next
12 months. If the VIX increases, then investors become more pessimistic and the financial
markets become more volatile. Some economists and analysts use the VIX as a recession
indicator, shown in Figure 1. During the 2008 Financial Crisis, the VIX peaked at 60, and the
stock markets lost roughly half their market value during 2009.