Question

Mention three pros and cons for each of the following derivatives

1. futures

2. forwards

3. options

Answer 1

1. Futures pros and cons are as follows:

Pros

a. These are traded on standardized markets or stock exchanges

b. Very low or negligible counterparty risk involved

c. Can be used to take large number positions on a stock at a single point of time, since in futures we buy lots instead of buying a single quantity of stock.

Cons:

a. Generally, the capital required to invest in futures contract is usually large

b. Sometimes in futures market there are issues of liquidity, due to which it becomes hard to buy or sell a particular stock

c. In futures market, there is a risk of high volatility, which could result in huge losses.

2. Forwards Contract pros and cons are as follows:

Pros:

a. Forwards contracts offers a complete hedge and also helps in mitigating the risk to much extent

b. There is no mark to market (MTM) requirement as is required in futures market

c. There is no immediate cash outflow on initiation of a contract, however it will result in cash settlement on expiry of period as mentioned in forward contract

Cons:

a. Since these are entered in two between two parties, there is a high probability of counterparty risk involved

b. These contracts are not traded on recognized stock exchanges, hence these are highly unregulated

c. Sometimes it might become a challenge to find a counterparty to enter in to this contract

Options Pros and Cons are as follows:

Pros:

a. Requires a smaller initial amount of investment as compared to buying a stock

b.Can act as hedge to the investors on the stock that they already holds.

c. If you buy a call or a put option, the risk is only limited to the option premium you have paid at the time of buying the call or a put option.

Cons:

a. Can expose an investor to unlimited losses

b. Sometimes there are liquidity issues on option contracts to buy or sell.

c. It is generally complex to understand options market and it takes more time to understand options as compared to simply investing in the stocks.