Question

Explain in 2 to 3 lines.

1.When we open a position, the costs are different between an options contract and a futures contract. Explain the difference between a premium and a margin account. Be sure to explain the various types of margins that are required and what costs each type of contract has.

2.Explain the idea of the "cost of carry" as it applies to futures contracts. Specifically, what factors can influence the difference between a spot and futures/forward price in the cost of carry? Now explain "convergence" as it relates to spot and futures prices as well as the cost of carry.

Answer 1

For an Options contract, Option buyers(both long call and long put) pay a fee which is known as premium to the option sellers(both short call and short put). This premium gives the right but not the obligation to the option buyers to exercise the options any time before expiration (American Option). Option Buyers carry the maximum risk in terms of losing this premium in case of options can't be exercised.    Future contracts are exchange traded products where exchange works as central courter party between different buyers and sellers. To alleviate any kind of counter party default risk, credit risk, each of the future traders need to maintain one margin amount with exchange. This basic margin amount is known as initial margin. Any party if dafaults after EOD M2M calculation, this margin amount is used to compensate the counter party. Every business day, after trading is over, M2M calculation done and unrealised profit or loss is added or deducted accordingly from the future trading initial margin account. Apart from this, each future trader needs to maintain one maintenance margin amount in a/c with exchange. This is generally a lesser amount than the inital margin. During EOD M2M calculation, if any trader a/c falls below maintenance amount, a margin call triggered from the exchange to that party. Now that trader need to add further margin to make up the shortfall and further continue trading.

Always the margin amounts in the futures market much higher than the options premium in OTC market. The cost of Initial margin is also higher than maintenance margin in futures market as explained earlier.

2.Cost of Carry applies to the futures market in terms of insurance cost, storage cost for underlying commodities, interest change in case of borrowed funds.

Basically cost of carry is the main difference between spot and futures/forward​ price. Dividend payout,reverse arbitrage applied by traders are few important factors influence cost of carry.

As future contracts delivery date approaches, the future price moves towards the undurlying asset's spot price. This movement is known as convergence. This happens not to give any arbitrage opprtunity to the traders.

Cost of Carry also reduces over the duration of future contracts. In that sense, cost of carry itself moves towards convergence. So, towards expiration, basis differences go and spot, futures price converge.