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Insurance-Linked Investments: Consider Your Options

Options strategies offer premiums for insuring against financial market risks. Joseph Mariathasan looks at strategies that attempt to collect these while protecting against the worst of the tail risks.

Seeking income is a challenge in a world where 10-year government bond yields are barely above 2% in the US and UK, and less in Germany. Higher yields can certainly be obtained in the bond markets by taking on credit risk. But it is also possible to generate higher income from other asset classes through taking on controlled risks by writing options, albeit with risk profiles that need to be well understood in a portfolio context, as well as on a stand-alone basis.

Buying a call option gives the purchaser the right to buy an asset at a fixed strike price within or at the expiry of a certain time period. Conversely, buying a put option gives the purchaser the right to sell an asset at a fixed strike price within or at the expiry of a certain time period.

The seller of the option receives a premium that is dependent on how far the strike price is above or below current market prices, the time to expiry, the interest rate for that period and how volatile the underlying asset’s price is estimated to be. As options are traded in the marketplace, the value of this ‘implied volatility’ can be calculated using standard option pricing formulae and the observed values of all the other variables.

Selling – or ‘writing’ – options without owning the underlying assets is akin to insuring against catastrophe risks. A strategy of continuously writing ‘naked’ options – where the underlying asset is not owned or sold short – would produce a steady income stream until the day when an option expires in-the-money.

Continued

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