Question

what determines the use and price of futures/forward and plain vanilla options

Answer 1

Ans ) Derivatives : Derivatives are financial instruments whose value is derived from other underlying assets. There are mainly four types of derivative contracts such as futures, forwards, options & swaps. However, Swaps are complex instruments that are not traded in the Indian stock market

Determination of future price

When a contract is 1st entered into, the price of a futures contract is determined by the spot price of the underlying asset, adjusted for time plus benefits and carrying costs accrued during the time until settlement. Even if the contract is closed out before the delivery date, these costs and benefits are taken into account in determining the price of the contract, since there may be a delivery. Benefits that accrue with ownership include dividends and interest that is paid by the underlying asset. Costs associated with ownership include storage costs, such as with oil, and the interest rate used to determine the present value of a transaction, which represents the opportunity cost of delaying the transaction. To simplify the following discussion, benefits and costs will be restricted to present value and income yield.

When a futures contract is initially agreed to, the net present value of the transaction must be equal for both parties; otherwise, there would be no agreement. The delivery price is the price agreed to in the contract. However, with time, the position of the parties will change as a spot price of the underlier changes, with the gains by one party equal to loss of the other party. As the settlement date approaches, the prices of the futures contract and its underlying asset must necessarily converge, so that on the delivery or settlement date, the futures price will equal the spot price of the underlying asset. Because futures contracts can be used to hedge positions in the underlying asset, a perfectly hedged position must necessarily yield the risk-free rate of return — otherwise, arbitrage opportunities would arise that would conform the rate of return to the risk-free rate of return.

forward price :

Forward price, or price of a forward contract, refers to the price that is agreed upon between two parties to trade a specific asset at a specific date in the future.
This is the price that the party assuming the long position to the forward will pay to the party in the short position, on maturity of the forward contract.

Theoretically, forward prices are calculated on the basis of ‘no arbitrage’ assumption. Arbitrage refers to making a risk-free trading profit. So, the ‘no arbitrage’ assumption means that we do not believe that a trader can make a risk-free profit, by the simultaneous buying and selling of a security.The relevance of this assumption is based on the fact that arbitrage opportunities very rarely occur in developed securities markets. Even when such opportunities do arise, they are quickly identified and eliminated by investors who try to take advantage of such a situation. It is assumed that under ‘no arbitrage’ conditions, any two securities or portfolios with exactly the same payments will be priced equally. This is called “The Law of One Price”.
Based on this assumptions we could find the forward price by creating a portfolio that replicates the payments of the underlying assets. The prices of both these portfolios (the portfolio containing the actual investment and the replicating portfolio) can be equated to determine the forward price.
It is also assumed that there are no transaction costs, taxes and similar expenses.

​​​​​​Difference between future and forward

A future contract is a binding contract whereby the parties agree to buy and sell the asset at a fixed price and a future specified date. The terms of a forward contract are negotiated between buyer and seller. ... Forward contracts are traded Over the Counter (OTC), i.e. there is no secondary market for such contracts.

Uses or advantage of future contract

While futures can pose unique risks for investors, there are several benefits to futures over trading straight stocks. These advantages include greater leverage, lower trading costs, and longer trading hours.

Uses and advantages of forward contract

The advantages of the forward contract are as follows;

They can be matched against the time period of exposure as well as for the cash size of the exposure. Forwards are tailor-made and can be written for any amount and term. Forwards are over the counter products. The use of forwards provide price protection.

Plain valina options

A vanilla option is a financial instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a given timeframe. A vanilla option is a call or put option that has no special or unusual features. Such options are standardized if traded on an exchange such as the Chicago Board Options Exchange.

Calls and Puts

There are two types of vanilla options: calls and puts. The owner of a call has the right, but not the obligation, to buy the underlying instrument at the strike price. The owner of a put has the right, but not the obligation, to sell the instrument at the strike price. The seller of the option is referred to as its writer. Shorting or writing an option creates an obligation to buy or sell the instrument if the option is exercised by its owner.

Calls and puts both have an expiry date. This puts a time limit on how long the underlying asset has to move.

Vanilla Option Features

Every option has a strike price. If the strike price is better than the price in the underlying market at maturity, the option is deemed "in the money" and can be exercised by its owner. A European style option requires the option be in the money on the expiration date in order for it to be exercised; an American style option can be exercised if it is in the money on or before the expiration date.

The premium is the price paid to own the option. The premium is based on how close the strike is to the price of the underlying (in the money, out of the money, or at the money), the volatility of the underlying asset, and the time until expiration. Higher volatility and a longer maturity increase the premium.

An option gains intrinsic value, or moves into the money, as the underlying surpasses the strike price— above the strike for a call and below the strike for a put.