Question

i. Answer the following questions about financial derivatives.

a. Address the similarity of forward, futures and option contracts. (5%)

b. Address the differences between option and forward/futures contracts. (5%)

c. Construct a table to address the differences between forward and futures contracts. (15%)

Answer 1

a. Futures, options and forward contracts are all derivative form of contracts between two parties. They are all used to hedge risks associated with the stock volatility and, a wide variety of commodities can be traded under their banner.

b. In option contracts, the payments are to made initially during agreement. In Future or Forward contracts, the payment is not done at the time of agreement. Secondly, Options give right to investors, they are not legally binding on them and hence they are least risky, whereas, both futures and forwards are legally binding and hence, have more risks compared to options.

c.

Forward Contracts	Futures Contracts
1. Can be customised between the parties and are non-standardized	They are standardized and cannot be customised
2. Are not traded in central exchanges	Traded in exchanges
3. Non-regulated and hence are riskier	Regulated and less risky than forward contracts.
4. They are open or readily available to general public	Easily traded by retail investors through exchanges.