CH 10 - 4 Futures and options

Question 1

4 Futures and options

1. Key Concepts

Answer 1

Derivatives: Financial instruments whose value depends on an underlying asset (e.g., equities, commodities).
Examples: Futures, forwards, options, and warrants.
Uses:
1. Hedging: Reduces risk.
2. Speculation: Increases risk to enhance returns.

Question 2

4 Futures and options

2. Forwards and Futures

Answer 2

Forwards:
* Non-standardized contracts to buy/sell an asset in the future on an agreed basis.
* Traded over-the-counter (OTC), not on an exchange.
* Tailor-made contracts negotiated between parties.
* Example: Ordering a car with specified price, model, and delivery date.
* Risk: Credit risk depends on the counterparty’s creditworthiness.

Futures:
Standardized contracts traded on a recognized exchange.
Standardization: All details (except price) pre-determined (e.g., asset type, quantity, delivery date).
Example: A standardized car contract specifies make, model, and delivery date.
Liquidity: Highly liquid due to standardization and ease of administration.
Clearing House:
* Guarantees trade by acting as a counterparty.
* Minimizes credit risk using initial margin (good faith deposit) and variation margin (price-based adjustments).

Positions:
Long Position: Positive exposure; contracted to buy the asset in the future.
Short Position: Negative exposure; contracted to sell the asset in the future.

Question 3

4 Futures and options

3. Options

Answer 3

Definition:
Right, but not obligation, to buy/sell an asset at a specified price on/before a set date.
Premium: Price paid by the option holder to the writer for the right.

Types:
Call Option: Right to buy.
Put Option: Right to sell.
Key Difference: Buying a put allows optional selling; selling a call obligates the seller to deliver.
Pricing Terms:

Strike/Exercise Price:
Price at which the asset is traded if the option is exercised.
Option Premium: Payment to writer for granting the right to trade.

Timing:
European Option: Exercised only at expiry.
American Option: Exercised any time before expiry.

Question 4

4 Futures and options

4. Warrants

Answer 4

Definition: Option issued by a company over its own shares.
Gives holder the right to buy shares at a specific price and time.
Does not provide voting or dividend rights but adjusts for share capital changes (e.g., rights issues).
Use Case:
Often issued with bonds to attract investors.
Benefits companies by raising finance efficiently.

Question 5

4 Futures and options

5. Uses of Derivatives

Answer 5

Hedging Examples:
Utility companies lock gas prices with futures for fixed tariffs.
Chocolate manufacturers secure cocoa prices using futures.

Speculation:
Traders profit from price differences without taking physical delivery of the asset.
Example: Buy sugar futures now and sell later at a higher price to profit from market movements.

Portfolio Management:
Insurance companies use options to manage risk without selling underlying equities.
Example: Buying a put to limit equity downside exposure while maintaining upside potential.

Cost Considerations:
Derivatives incur costs (e.g., premiums, collateral).
Useful for obtaining economic exposure without directly holding the asset.

Question 6

6. Key Takeaways

Answer 6

• Forwards: Flexible but OTC with credit risks.
• Futures: Standardized, exchange-traded, and low credit risk.
• Options: Flexible rights with costs; vary by exercise timing.
• Warrants: Issued by companies; attractive for investors and cost-effective for issuers.
• Applications: Risk control (hedging) and profit-seeking (speculation).