By Brian A. Eales (auth.)

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9') where: E represents the exercise or strike price, and ST represents the value of the underlying security at expiration. 8 represent the kinked payoff profiles oflong call, long put, short call and short put options, respectively. Returning to the case of the equity fund manager running an index-tracking portfolio, the idea of hedging the portfolio against market falls can be regarded as taking out a form of insurance. Since an option bestows on its holder the right but not the obligation to exercise at expiration, the fund manager can select an appropriate exercise price and hedge the downside risk associated with the portfolio, but he/she can allow the option to expire worthless should the market move in the opposite direction to his/her view or forecast.

Semi-annual interest (coupons) on US, Japanese, and UK bonds, annual interest payments made on Eurobonds, German and French bonds, whereas outlay can be face value or a discount on a discount instrument, or the market price paid for a new issue or secondary market bonds which may be priced at par, at a premium or at a discount depending on issue coupon, and current interest rates. 16). 16) where the variables in each equation are as defmed previously. , and day counts for calculating these payments will also vary between bond markets just as they do in the money markets.

This is the case with contracts on Government bonds where, when settlement occurs, a bond meeting some defmed criteria will be transferred from one party in the transaction to another. It is also the case in options on equity where a defmed number of shares - usually 1,000 for LIFFE contracts - will need to be transferred. Options will be discussed later in this chapter. 1 Futures Applications To demonstrate some of the uses to which futures contracts can be put consider the case of a fund manager with investments in blue-chip shares that track an equity Financial Engineering 34 index on which futures are available.

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