by Peter Fortune
July/August 1995

Trading volume and open interest in options and futures contracts on stock indices, equities, and interest rate instruments traded on world exchanges have experienced remarkable growth. However, this growth has been accompanied by controversy about the proper role of financial derivatives and the potential for abuse. Prominent attention has been given to losses by major corporations, broker-related short-term mutual funds, and municipal agencies.

The public debate about "derivatives" has promoted the impression that the heart of the problem has been a proliferation of brand new ways of making bets on future stock prices, interest rates, and exchange rates. The positive functions of derivatives as means of risk management are almost forgotten.

This article shows that exchange-traded options are really nothing new. Rather, they are repackages of the same traditional financial instruments. The article describes the practical application of the equivalence between exchange-traded options and a traditional portfolio of stocks and bonds. This is done by demonstrating the strategies of dynamic hedging and of portfolio insurance. The first uses options to hedge against stock price movements, while the second uses stocks and bonds to create "synthetic" options.