Question

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6. Two derivative products that may be offered through a stock exchange are an options contract...

6. Two derivative products that may be offered through a stock exchange are an options contract and a futures contract. Briefly explain the main features of each of these products. Why might an investor use these products?

Expert Solution

Options Contract:

This contract gives the buyer of the contract the right (not obligation) to buy/sell something (security) in future at a specified price. Features:

-Strike Price: The price at which the option owner can buy/sell the security in future.

-Expiry Date: Every option has an expiry date after which option hold no value.

- Flexibility: Options in OTC world are highly flexible and can be designed as per the needs of buyer/sellers. For exchange (non OTC) world, options are standardized. Hence, we have a combination of a forward and a future contract.

- Premium - Buyer of the option has to pay some amount as down payment known as the premium as the buyer as the privilege to use the option in future if conditions are favorable.

- Settlement: If the option is not used (exercised), then seller of the option keeps the premium money and the deal is over. There is no exchange of any security in options.

- Non-Liner Profit/losses: Profit and losses in options are not symmetrical when we plot them on graphs.

Why Investor use this?

- For hedging

- It gives a leverage position to the buyer of options, instead of making a full purchase

- It limits the risk of the option owner

- potential for higher returns

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b) Futures contract

It is a legal agreement which bounds/compel the party to buy/sell the specified security in future at a specified date and price.

These are standardized contracts.Features:

- They are traded on exchange only and are hence standardized with low scope of flexibility compared to OTC options

Clearing house has the major role in this. Clearing house acts as the buyer and seller of contracts to parties.

- No/limited default risk

- Highly regulated

- Margins (Initial margin and Variation margin) are used to cover the risk.

- Actual delivery is a very rare scenario.

Why Investor use this?

- For hedging and speculation

- These are highly leveraged as the investor/buyer of future contract has to invest only a small fraction of the total amount in order to enter into a future contract. This is called margin amount.

- Low execution costs and admin cost

- Future markets are more fair, liquid and efficient

- Short selling is allowed

jeff jeffy answered 6 months ago

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