Chapter 2: Derivatives (2)

Question 1

Forward contract (un-margined)

Answer 1

An un-margined forward contract is a non-standardised contract between two parties to trade a specified asset on a set date in the future at a specified price.

Question 2

Differences between (un-margined) forward contracts and futures contracts (8)

Answer 2

Futures vs (un-margind) Forward contract

1. exchange-traded vs normally over-the counter (OTC)
2. standardised vs tailored
3. highly marketable vs non-marketable
4. liquid vs illiquid
5. minimal counterparty credit risk vs counterparty credit risk
6. (delivery price determined openly by buyers and sellers in the marketplace) vs (delivery price negotiated privately between buyer and writer)
7. index futures readily available vs contracts normally based on specified underlying security.
8. can be closed out prior to maturity and most are! vs difficult to close out and so usually settled at maturity.

Question 3

State the two different types of option and how they differ.

Answer 3

1. American options
2. European options

American options can be exercised at any time up to the expiration date and European options can only be exercised on the expiration date.