Question

Choose one derivative product: credit default swap, interest rate swap, currency swap, forwards, futures or any other derivative security you found interesting.

definition of the instrument, simple explanation how the instrument works, as well as description of potential investor`s profiles (i.e who and why usually buy the instrument)

Answer 1

Options:

Definition:

Options are derivative instruments that give the buyer the right but not the obligation to buy or sell the underlying asset at a predetermined price (known as the Strike price or Exercise Price ) at a specified date in the future(known as the expiry or the maturity date).

Since the buyer of an option has the right but not the obligation to buy or sell the underlying asset therefore to purchase this right the buyer has to pay the seller a price at the time of entering the contract known as the premium.

Before we understand how an option works we need to know about the two broad types of options:

Call Option:Call option is a type of option wherein the option buyer has the right and not the obligation to buy the underlying asset at a predetermined price at a specified date in the future.

Put Option:Put Option refers to a type of option wherein the option buyer has the right and not the obligation to sell the underlying asset at a pre-determined price at a specified date in the future.

On the basis of expiry :options are of the following two broad types:

European Option: An European Option is a type of call or put option that can be exercised only at its expiry date.

American Option: An American Option is a type of call or put option that can be exercised anytime on or before the expiry date.

Now let us understand how an option works with the help of an example:

Suppose an individual buys a $ 200 three-month call option of XYZ Ltd at $ 80 .The spot price of XYZ Limited's share is $ 150 .

On Expiry(ie.after three months): Suppose the spot price on expiry is $ 100:

The call option holder will exercise(ie. buy) if the strike price of the call option is lower than the spot price.But here the strike price of $ 200 is higher than the spot price of $ 100 so the call option holder(buyer) will not exercise the option.

But he has paid the premium of $ 80 at the time of entering the contract so he will incur a loss of $ 80.

Now suppose on expiry: the spot price is $ 300 :(all other things remain unchanged)

Now the spot price of $ 300 is higher than the strike price of $ 200 so the call option holder will exercise the call option and will make: (Spot Price-Strike Price-Premium) ie. ($300-$200-$80) ie. $ 20 profit (Premium will be deducted as it has been paid at the time of entering the options contract).

Call Option Buyers:

Call Option Buyers are investors who expect to buy (long) the underlying asset at some specified date in the future to meet some contractual obligations and expect the price of the underlying to rise in the future thus to hedge against this loss they buy call options. A call option buyer will have a loss limited to the extent of premium paid and unlimited profit(if the underlying price starts rising)

Put Option Buyers:

Put Option Buyers are investors who expect to sell the underlying asset at some specified date in the future to meet some contractual obligations and expects the price of the underlying to fall in the future and thus to hedge against this loss they buy put options.A put option buyer will have a loss limited to the extent of premium paid and unlimited profit(if the underlying price starts falling)

Call Option Sellers and Put Option Sellers:

Call Option Sellers and Put Option Sellers have exactly the opposite sentiments to the call option buyers and put option buyers.In other words: a call option seller expects the price of the underlying asset to fall in the future and hence sells the call option ,on the other hand, the put option sellers expect the price of the underlying to rise in the future and hence they sell put options .

A call option seller and a put option seller will make a profit to the extent of the premium received and unlimited loss(if the underlying price rises (call) or falls(put)