DERIVATIVE
SECURITIES 10-3
Background and Markets
When options were first traded, contracts were arranged between pairs
of investors and customized to meet specific needs. These customized
contracts could vary according to exercise price, expiration date, and
underlying asset. Because of these infinite possibilities, it was nearly
impossible for a secondary options trading market to exist. Investors
would enter into customized agreements according to their investment
needs; if their needs changed, it was difficult to find another investor
to buy the option contract.
Secondary
markets
This lack of liquidity and standardization was one of the driving
forces behind the creation of the Chicago Board Options Exchange
(CBOE) in 1973. The CBOE enacted rules to standardize option
contracts in order to restrict the number of contract types that would
trade on the exchange. Soon, other option exchanges were created.
This led to a broader standardization of option contracts and was the
key to creating a secondary market for options and increasing the
liquidity of option contracts.
Customized option contracts are still available to investors -- they
are traded in over-the-counter (OTC) markets. These customized
options are usually considerably more expensive than the standard
option contracts because of the lack of liquidity.
Standardized
contracts
The first standardized contracts were for the purchase or sale of
common stock. However, investors soon created demand for options
on a variety of financial and physical assets, including options on:
·
Common stock
·
Stock indices
·
Debt instruments
·
Interest rate futures
·
Foreign currency futures
·
Agricultural commodities
·
Precious metals