Chapter 10: Managing Market Risk with Options

Chapter 10 is the final chapter of a pedagogical trilogy on the three principal types of instruments used in market risk management. Chapter 8 was on forwards and futures, and Chapter 9 was on swaps. Because they are slightly more complex than forwards, futures, and swaps, we have saved options for last, though the wait should be worth it. What makes options more complex is that they have non-linear payoffs, meaning that their payoffs are not related to the underlying in the same way over the full range of possible underlying values at the expiration or settlement dates. In contrast, forwards, futures, and swaps have linear payoffs, meaning that the payoffs are the same function of the underlying regardless of the level of the underlying. If this point is not clear, do not worry. We will cover it in detail, and it will become clear. So, let us get started with understanding just what an option is.