Explain why for speculation, the purchase of an option may be more attractive than a futures contract or the outright purchase of the underlying asset.

Question

What will be an ideal response?

Answer 1

Let's say an investor believes that interest rates are going to fall over the next few months. There are three ways to bet on this possibility. One is to purchase a bond and if the investor guesses correctly, the bond price will rise as the interest rate falls. This is expensive since it requires the purchase of the bond. Another strategy is to purchase a futures contract, meaning take the long position. If the market price of the bond increases with falling interest rates, the investor will reap the profits. This approach requires a small investment, but this approach is also very risky since the investment is highly leveraged since the market price can move against the investor. A third strategy involves the use of an option. The investor could purchase a call option on a Treasury bond. If he or she is right and interest rates fall, the value of the call option will rise, which is the upside. On the other hand, if the investor bets wrong and interest rates rise, the option will expire worthless and the investor just loses the fee paid for the option. The bet is both highly leveraged and limited in its potential losses.