Financial option insurance

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Financial Option Insurance Qi-Wen WANGa and Jian-Jun SHUb aSchool of Business, Shanghai DianJi University, 1350 Ganlan Road, Lingang New City, Pudong New District, Shanghai 201306, People’s Republic of China bSchool of Mechanical & Aerospace Engineering, Nanyang Technological University, 50 Nanyang Avenue, Singapore 639798 ABSTRACT The option is a financial derivative, which is regularly employed in reducing the risk of its underlying securities.
However, investing in option is still risky. Such risk becomes much severer for speculators who utilize option as a means of leverage to increase their potential returns. In order to mitigate risk on their positions, the rudimentary concept of financial option insurance is introduced into practice. Two starkly-dissimilar concepts of insurance and financial option are integrated into the formation of financial option insurance. The proposed financial product insures investors’ option premiums when “misfortune” befalls on them. As a trade-off, they are likely to sacrifice a limited portion of their potential profits. The “loopholes” of prevailing financial market are addressed and the void is filled by introducing a stable three-entity framework. Moreover, a specifically designed mathematical model is proposed. It consists of two portions: the business strategy of matching and a verification-and-modification process. The proposed model enables the option investors with calls and puts of different moneyness to be protected by the issued option insurance. Meanwhile, it minimizes the exposure of option insurer’s position to any potential losses. Key Words: business strategy of matching; risk management; portfolio insurance; futures options

1. Introduction Contemporary financial market is always associated with the increasing volatility and uncertainty. The market participants, no matter individual investors or institutional traders, are unavoidably exposed to the risk1 induced by the random events, which is generated by economic environment (central bank monetary policies, inflation, business cycles, global financial events, critical economic data announcement, etc.). Therefore, there is always a saying among traders: “Trading may have princes, but nobody stays a king” [1]. In order to beat the market, agile and accurate anticipations based upon real economic activities are the essential skills for individual investors, fund managers, and corporate financial managers. However, by contrasting the past predictions with respect to the actual financial market movements, the result remains pessimistic [2]. The financial market hates uncertainties, as any inappropriate strategies can simply spell catastrophic consequences to their retirement account, representing clients as well as organizations because of a considerable amount of money involved. Nowadays, due to the highly globalized nature of all large economies, any ominousness in one sector would be quickly disseminated, and ultimately become a global nightmare.

 Correspondence should be addressed to Jian-Jun SHU, mjjshu@ntu.edu.sg 1 Risk: In financial market, five types of risks are generally encountered by market participants, including market risk, opportunity risk, inflationary risk, credit risk and liquidity risk. Source: Risk Management-Journal of Risk Crisis and Disaster, Vol. 19, No. 1, pp. 72-101, 2017; DOI: 10.1057/s41283-016-0013-5

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Therefore, in the perspective of market participants, it is always ideal to seek out an avenue to reduce the potential risk of their portfolio. Even in the perspective of the government, it is always optimal to introduce one additional entity to contemporary financial market, which helps to redistribute and regulate the risk among entities. With the introduction of equity option into the prevailing financial market, the variety of trading strategies is significantly enriched. Constructing a well-diversified portfolio2, which balances out or limits the exposure of underlying asset to any potential market fluctuations [3], becomes a plausible solution. Nowadays, the most actively traded financial derivative3 is option, which represents a contract sold by an option seller (writer) to an option buyer (holder) in exchange for the credit (an option premium4). Such a contract offers the holder a right, but not an obligation, to either buy (call) or sell (put) a specific financial instrument (underlying security) at a specific price (strike price5/exercise price) on (or prior to) a predefined date (maturity date). If the option is in-the-money (ITM6) on (or prior to) its maturity date, the option holder chooses to exercise the right (option), therefore, the option writer is obliged to deliver the underlying asset to the op

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