Proactive hedging option holders, per their namesake, seek to proactively cover their risk of exposure; the option writers
only bear a residual portion of the risk.
In short, the option writer is contractually entitled to the
should be evident that the option writer is the one who is at risk of
opposite direction, from the option writer to the option holder, not, as
the inception of the contract, H had agreed to pay W, the option writer,
An insurance policy holder (the option buyer) has shifted the risk of financial losses from an event (managed the risk) to the insurance company (the option writer
command more premium for taking that risk, but the proportional price increase in premium is far larger the nearer the option is to expiration.
If V(T) is higher than [D.sup.*], the option writer can afford to pay all the claim.
Unlike the options traded in regulated exchanges, there is no organized exchange to ensure that option writers will fulfill the contractual obligations in the OTC markets.
They also note that option writers should be compensated for bearing the risk of shocks in volatility.
This right/obligation asymmetry that is inherent in options prompts the risk-averse option writers to mark up the premium to account for any unexpected hike in volatility.
Their difference, [[sigma].sub.R.sup.2] - [[sigma].sub.rn.sup.2], is the volatility or variance risk premium demanded by option writers. In Bakshi and Madan (2005), [[sigma].sub.rn.sup.2] is an explicit function of [[sigma].sub.R.sup.2], as well as skewness and kurtosis of the physical distribution.