The Role and Importance of the Options as a Unstandardized Financial Derivatives Aleksandar Dejanovski 1 1MIT University, Skopje, Macedonia Abstract - The financial derivatives are financial result, this financial derivative doesn’t have to be instruments, that are recently created, and whose main executed from the buyer, but when is, the seller, application is to be used as a tool for managing always have to pay the contracted sum of money, or financial derivatives. The most significant financial other financial assets. The value of the options is derivatives are options, that are mostly used for their derived from the value of stocks, stock indexes, flexible and non-standard character. Options, and the other financial derivatives, as well, are instruments foreign currencies and futures. These financial that are derived from some other financial instruments are known as “basic assets”. The options instruments, that makes them more complicated from are used for: one hand, and more risky, from the other hand. Their role is very important for the developing the financial • To protect certain position or to reduce risk [1]. system, and generating economic growth. • In the case of buying options - for requiring or The subject of research in this paper is the options as a selling the underlying assets at favorable price in unstandardized financial derivatives, and their basic the future. characteristics and usage in developed, and developing • In case of options selling - to making additional countries. The prime goal is to research the importance income. of these derivatives in developing countries, with basic focus in the Republic of Macedonia. The results from The second and the third purposes are from these paper should suggest if the options are crutial for speculative nature, but the first purpose is actually the developing the Macedonian financial markets. the basic purpose of financial derivatives such as options, risk reduction and hedging. Keywords: Financial derivatives, options, hedging, The main difference between the options and call option, put option, short position, long position. some other financial derivatives is that the holder of the option has the right to decide whether it will be used, ie realized, or not, while the futures, swaps and forwards doesn’t give that right. The other financial 1. Introduction derivatives, both parties are obliged to fulfill the obligations arising from the contract. Although the Options are financial instruments that primarily option holder (buyer) has the right to leave are used in developed countries and are applied for unrealized option, with signing the contract, he has to reducing unnecessary risk, that exist. The process of pay a certain amount called the premium. Unlike the using a financial instrument in order to reduce the buyer of the option, the seller of the option has no risk in financial theory is known as hedging. The exclusive right. By the signing of the contract the options are specific form of financial derivatives buyer receives the same premium as the price of the because of its popularity and unstandardised form, sold option, but is obliged, in the future, to pay that are used in developed and developing countries, certain amount of money if the option buyer realize as well. Options, as a financial derivatives, are (execute) the option. So we can conclude that the financial instruments that have been derived from seller and buyer of the optional agreement are not in another financial instrument’s value. equal condition. This asymmetry is result to the Options and all financial instruments have their optional contract. Despite the options, buyers and value derived from the value of another financial sellers of futures, forwards and swaps are placed in a instrument. These instruments have a price of symmetrical position with equal rights and execution, maturity date, period of validity, cost of obligations. conversion and other basic elements that together Options are contracts through which a seller with the price of the underlying asset, affect the value gives a buyer the right, but not the obligation, to buy of the option. The option is a financial derivative that or sell a specified number of shares at a gives the holder the right to realize the same option predetermined price within a set time period. [2] over specific time. It’s up to the user to decide, if he From the definition, we can determinate the basic wants to execute the option or not, and when. So, as a elements of an option agreement: TEM Journal – Volume 3 / Number 1 / 2014. 81 www.temjournal.com • The basic assets are financial instruments • Call option, or option that gives right to buy the underlying the optional contract. Some basic underlying asset at the cost of execution in assets can be considered stocks, stock indexes, future time. foreign currencies and futures. • Put option, or option that gives right to sell the • Buyer has to pay the the option seller certain underlying asset at the specified price within a amount of funds, known as an option premium, specified time in the future. which can be regarded as the price of the option. Within paying the premium, the buyer has By the second criterion, the options are systematized bought the option and can execute in the future, by the possibility to be realized before the end of the when he decides, while the issuer or seller of the specified period: option gives the buyer the right, in that period or earlier (depending on the type of option) to sell • The European type options doesn’t allow or buy the asset that is subject of the option conversion before the specified day of delivery contract , ie to buy or sell the underlying (basic) (expiration date), the expiration date specified in asset at a fixed price. the optional contract at the time of signing the • The option that gives the buyer the right to buy same. This feature of the European type reduces any financial assets in future is known as call the market liquidity and makes them less option, while the option that gives the buyer the attractive trading instruments. right, or the owner the option to sell the basic • Unlike the European type of options, the asset (as currency or action) is known as the put American type allowed the option to be option. implemented before the expiry date of the • The options have a period of execution that contract, which increases flexibility and liquidity differ according to the type of the option. In of financial instruments and markets as well. European type of options, the execution is done American type of options is more attractive in exactly certain day in the future, so it is instrument from the European types, because if predetermined and can’t be changed. While the there were some positive trends in the options American type of options, although there is market, the option value would increase in the specific day for execution of the option, it is also future, so the investor wouldn’t have to wait for to be executed earlier, in a shorter time interval. the expiry date of the contract, and can execute • The cost of executing is a predetermined value ie the option before the selling the option and could price at which the option will be executed in earning money, that can be used for other future. The buyer will execute the option, only if investments. the price of the underlying asset decreases and drops below the price of the option. At that According the third criterion the options can be point, the option would worth more than the categorized, according to the type of underlying underlying assets and the buyer would realize assets: (execute) the option. If the price of the underlying assets should remain equal or • Stock options increase further, it wouldn’t be valuable to • Stock index options execute the option, and the buyer would left it • Future options unexecuted. • Product options • All the features of a particular type (put or call), derived from a particular action are called In the proceeding we are going to pay attention to the specific class options, and all options of a given option payoffs. Buying a call option involves buying class with the same price and the same execution the right to buy the underlying asset in the future at a date of realization are known as a specific series price of execution. The buyer is obliged to pay an of options. optional premium in the hope that the future price of the underlying asset will rise. If the cost of the assets 2. Types and Payment Options grows over the price plus the option premium paid then the buyer will realize (execute) the option, and In theory and practice there are several types of gain some profit, but if the price of the asset options that can be divided according to three decreases, then the investor shouldn’t exercise categories: option, because it is not profitable action, and then According to first criteria, by selling or buying the the overall loss for the buyer will be equal to the underlying assets, there are: premium paid. 82 TEM Journal – Volume 3 / Number 1 / 2014. www.temjournal.com option payoff Figure 1. Long call option payoff [3] Figure 3. Long put option payoff Selling the call option involves selling the right to Selling a put option involves selling the right to buy the underlying asset in the future. The seller gets sell the underlying asset at a price in future. The the optional premium immediately after signing the profit of the seller is the premium which is agreed by contract and it is his only income that can be contract.