Call Options

Definition

A call option is a type of financial derivative contract that gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price within a specific time period. Call options are used to manage risk and speculate on the future price movements of the underlying asset.

5 Must Know Facts For Your Next Test

1. Call options provide the holder with the right, but not the obligation, to buy the underlying asset at the strike price, which can be useful for managing risk and speculating on price movements.
2. The value of a call option is influenced by factors such as the current price of the underlying asset, the strike price, the time remaining until expiration, and market volatility.
3. Call options can be used to hedge against the risk of an increase in the price of an underlying asset, as the option holder can exercise the option to buy the asset at the lower strike price.
4. Investors can use call options to speculate on the future price of an underlying asset, with the potential to profit if the asset's price rises above the strike price.
5. The risk of holding a call option is limited to the premium paid for the option, which is the maximum amount the holder can lose if the option expires out of the money.

Review Questions

• Explain how call options can be used to manage risk in the context of exchange rates and international transactions.
  • In the context of exchange rates and international transactions, call options can be used to manage the risk of an unfavorable movement in the exchange rate. For example, a company that needs to make a payment in a foreign currency in the future can purchase a call option on that currency. This gives the company the right, but not the obligation, to buy the foreign currency at a predetermined exchange rate. If the exchange rate rises, the company can exercise the call option and buy the foreign currency at the lower strike price, mitigating the impact of the unfavorable exchange rate movement. This can help the company manage its exposure to exchange rate risk and ensure more predictable cash flows for international transactions.
• Describe how the value of a call option is influenced by changes in the underlying asset's price, the strike price, and the time remaining until expiration.
  • The value of a call option is primarily influenced by three key factors: the price of the underlying asset, the strike price, and the time remaining until the option's expiration. As the price of the underlying asset increases, the value of the call option generally increases, as the option holder has the right to buy the asset at a lower strike price. Conversely, if the underlying asset's price decreases, the value of the call option decreases. The strike price also affects the option's value, as a lower strike price makes the option more valuable. Finally, the time remaining until expiration is important, as options with more time until expiration tend to be more valuable, as the holder has a longer period to potentially benefit from favorable price movements in the underlying asset.
• Evaluate the potential risks and benefits of using call options as a hedging strategy against exchange rate fluctuations in international transactions.
  • The potential benefits of using call options as a hedging strategy against exchange rate fluctuations in international transactions include the ability to limit downside risk, maintain upside potential, and improve cash flow predictability. By purchasing a call option, a company can protect itself against an unfavorable rise in the exchange rate, while still being able to benefit if the exchange rate moves in a favorable direction. However, the potential risks include the cost of the option premium, the risk of the option expiring out of the money, and the potential for the underlying asset's price to move in an unexpected direction. Additionally, the complexity of options trading and the potential for leverage to amplify losses must be carefully considered. Ultimately, the decision to use call options as a hedging strategy should be based on a thorough analysis of the company's specific risk exposure, financial resources, and risk tolerance.

Related terms

Put Option: A put option is a financial derivative contract that gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price within a specific time period.

Underlying Asset: The underlying asset is the financial instrument, such as a stock, bond, or commodity, that is the subject of a derivative contract like a call option.

Strike Price: The strike price is the predetermined price at which the holder of a call option can buy the underlying asset if they choose to exercise the option.