Question

An analyst comments that options are always better than forwards or futures given you have the right but not the obligation to exercise these. This implies that the payoff is bounded below by $0. In the case of forwards or futures you can face negative payoffs. Therefore, options will always be more profitable for the buyer. True or False and explains

Answer 1

True

The most commonly used derivatives contracts are forwards, futures and options.

Option

Options are of two types– calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Advantages of option

• You Choose Your Probabilities of Making Money on Trades
• Lower Capital Requirement
• Options Can Be Used to Reduce Risk
• Stock Investing and Options Are Perfect Complements
• Options Provide You With The Ability to Use Leverage
• Options Allow You to Customize Your Strategy
• You'll Be More In Tune With The Economy

Futures

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardised exchange-traded contracts. A speculator expects an increase in price of gold from current future prices of Rs. 9000 per 10 gm. The market lot is 1 kg and he buys one lot of future gold (9000 × 100) Rs. 9,00,000. Assuming that there is 10% margin money requirement and 10% increase occur in price of gold. the value of transaction will also increase i.e. Rs. 9900 per 10 gm and total value will be Rs. 9,90,000. In other words, the speculator earns Rs.
90,000.

Forward

A forward contract is a customised contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. For example, an Indian car manufacturer buys auto parts from a Japanese car maker with payment of one million yen due in 60 days. The importer in India is short of yen and suppose present price of yen is Rs. 68. Over the next 60 days, yen may rise to Rs. 70. The importer can hedge this exchange risk by negotiating a 60 days forward contract with a bank at a price of Rs. 70. According to forward contract, in 60 days the bank will give the importer one million yen and importer will give the banks 70 million rupees to bank.