THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 401

CHAPTER 14 Risk Management with Financial Derivatives 369 these contracts Of course, these losses are offset by unrealized profits in the rest of the bank s portfolio, but the bank is not allowed to offset these losses in its accounting statements So even though the macro hedge is serving its intended purpose of immunizing the bank s portfolio from interest-rate risk, the bank would experience large accounting losses when interest rates fall Indeed, bank managers have lost their jobs when perfectly sound hedges with interest-rate futures have led to large accounting losses Not surprisingly, bank managers might shrink from using financial futures to conduct macro hedges for this reason Futures options, however, can come to the rescue of the managers of banks and other financial institutions Suppose that First Bank conducted the macro hedge by buying put options instead of selling Canada bond futures Now if interest rates fall and bond prices rise well above the exercise price, the bank will not have large losses on the option contracts because it will just decide not to exercise its options The bank will not suffer the accounting problems produced by hedging with financial futures Because of the accounting advantages of using futures options to conduct macro hedges, option contracts have become important to financial institution managers as tools for hedging interestrate risk Factors Affecting the Prices of Option Premiums There are several interesting facts about how the premiums on option contracts are priced The first fact is that when the strike (exercise) price for a contract is set at a higher level, the premium for the call option is lower and the premium for the put option is higher For example, in going from a contract with a strike price of 110 to one with 115, the premium for the February call option might fall from 39/64 to 1/64, and the premium for the March put option might rise from 15/64 to 28/64 Our understanding of the profit function for option contracts illustrated in Figure 14-3 helps explain this fact As we saw in panel (a), a higher price for the underlying asset (in this case a Canada bond futures contract) relative to the option s exercise price results in higher profits on the call (buy) option Thus the lower the strike price, the higher the profits on the call option contract and the greater the premium that investors like Irving are willing to pay Similarly, we saw in panel (b) that a higher price for the underlying asset relative to the exercise price lowers profits on the put (sell) option, so that a higher strike price increases profits and thus causes the premium to increase The second thing is that as the period of time over which the option can be exercised (the term to expiration) gets longer, the premiums for both call and put options usually rise For example, at a strike price of 114, the premium on the call option might increase from 1/64 in February to 4/64 in March and to 7/64 in April Similarly, the premium on the put option at a strike price of 111 might increase from 8/64 in February to 32/64 in March and to 13/64 in April The fact that premiums increase with the term to expiration is also explained by the nonlinear profit function for option contracts As the term to expiration lengthens, there is a greater chance that the price of the underlying asset will be very high or very low by the expiration date If the price becomes very high and goes well above the exercise price, the call (buy) option will yield a high profit, but if the price becomes very low and goes well