Question

1. Answer the following questions about financial derivatives.

1. Address the similarity of forward, futures and option contracts. (5%)
2. Address the differences between option and forward/futures contracts. (5%)
3. Construct a table to address the differences between forward and futures contracts. (15%)

Answer 1

a) Forward, futures and options contract are all types of derivative which are used by investor to hedge their position. The investor can use these kinds of derivative instrument to hedge their current position or speculate on the market movement and bet on that and generate return on that. All these derivatives can be used by the investors for taking either short position or long position or for speculation activity. If the investor is currently having a long exposure and want to reduce the exposure then forward, future and options any of them can be used to take offsetting position and reduce the exposure. Similarly, if an investor is having a short position then again, these derivatives can be sued to take offsetting position and reduce the exposure. All these derivatives contracts offer the investor more or less similar risk and reward scenario, it is the investor who has to decide which one to go for according to his own risk tolerance level.

b) Option gives the investor the option to either buy or sell but not the obligation when you buy a call option you have the option to buy at the strike price but not the obligation, similarly when you buy the put option you have the option to sell but not the obligation. Forward is different from options because here the agreement entered has to be executed, it is an obligation for both the parties, similarly future contract is an obligation for both the parties but future contract is more standardized form of forward contract, futures are traded on exchange.

c) The differences are

Forward	Futures
Forward is contract between two parties similar to a private agreement between two parties.	Future is a more standardized form of forward contract because here the contract is standardized not accustomed to individual requirement.
There is counterpart risk in forward contract, the risk of default by the other party.	There is no counterparty risk because it is mark to marked on daily basis and clearing house does the transaction.
Forward is better when you need to customized the transaction according to your need.	Future contracts cannot be customized.
Forwards are not traded om the exchange but on the over the counter market	Futures are traded on the exchange so there is high liquidity.