Suppose you are the risk manager of a pension fund invested in the financial market and you know that in T years the fund needs to pay out €K million in retirement money to the investors. If your fund consists of many risky investments like stocks, the value could be more than €K million, but also less. A possible way to protect the fund is to enter into a contract that guarantees a minimal value of €K million for your assets in T years. Such a contract gives you the right to sell the pension fund at a guaranteed price of €K million in T years time, but if the fund is worth more you are not obliged to do so. Your counterpart, however, is committed to buying your portfolio if its market value is less than €K million. You have entered into a financial contract called a (European) put option.
KeywordsStock Price Pension Fund Call Option Normal Random Variable Strike Price
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