Supervisory Aspects of Options Pricing

Derivatives trading, and the trading of options in particular, raises special challenges both for market participants and for supervisory agencies. In contrast to traditional financial instruments, which typically involve outright sales or purchases of assets, options are unique in that they confer the right, but not the obligation, to buy or sell some underlying asset at a pre-agreed price in the future. That novel feature of options makes them an effective and often relatively inexpensive means of providing insurance against uncertain future events. For the buyer of an option downside risk is limited – the most that can be lost is the up-front premium paid for the option. Conversely, the profit to a seller of an option is capped at the premium value, while losses, in theory, may be infinite. It is the asymmetry in the option’s payout, which derives from the uncertainty as to whether an option will or will not be exercised by a buyer, that greatly complicates the task of determining the value of the option and how it will change over time as events unfold. The factors explaining the price of any option are encapsulated in option pricing models. Supervisory Aspects of Options Pricing