Futures, Forwards and Options - Assignment Example

Futures, Forwards and Options Introduction In finance, a derivative refers to a financial contract that achieves its valuation from the performance of a different entity that might be in the form of an interest rate, an index, or an asset. These entities are collectively known as the underlying. A derivative is one of the dominant categories in the three financial instruments that also include debts and equities. Under derivatives, several financial contracts include futures, options, swaps, and forwards. Generally, derivatives are used in various purposes like hedging and speculation. This study will, however focus on three derivatives only; futures, forwards, and options contracts and evaluate their roles in risk reduction, arbitrage purposes, and speculation. Futures Futures are also known as futures contracts in finance. By definition, a futures contract is one that is standardized and features two different parties who agree to buy and/or sell a specific asset with a standard quality and quantity for a price that is agreed on before the actual delivery and payment occurs. However, the delivery and payment day, which occurs on a future date is specified and fixed, and is referred to as the “delivery date” (Suitcliffe 2006, p. 19). For instance, one may need to buy a specific make of an asset, such as a Smartphone that happens to be out of stock at a certain shop. Owing to the fact that he needs that one make of the phone, they can come to terms with the proprietor that he imports the phone from elsewhere, then sells it to the buyer later for a price that they agree on at that current time. This contract’s negotiation takes place at a futures exchange. A futures exchange or market is itself a neutral financial exchange in which trades of standardized futures occur. In short, a futures market acts as an intermediary between the buyer and seller and sees to it that they come to an agreement regarding the exchange of commodities or financial instruments at a certain time with a specific future delivery time (The Telegraph 2014). The party willing to acquire an underlying asset in a later time (future) is called the buyer of the futures contract, whereas the party willing to sell the same is called the seller of the contract. Since the buyer of the contract has the permission to make a deal and await delivery without any variations to the price, he is referred to as “long”. The seller on his part who has the mandate to deliver the asset on the specified date without altering the price to the buyer is referred to as “short”. A futures contract, with the assistance of the futures market, is meant to reduce the potential risks of default that may arise from either of the two parties. Such contracts require the buyer and seller to pay an initial cash amount that acts as a performance bond and is called the “margin” in the contract. On another aspect, futures contracts also support speculation, which is the engagement in financial transactions that are risky by attempting to reap from medium to short fluctuations in market value of a good. Speculation further reduces risk in that it provides liquidity in the exchanges when participants from other categories are absent by absorbing excess risks (Business Case Studies 2014). The delay in the exchange process also allows for arbitrage in that during the “wait”, price variations, thus differences occur between markets, which leave the opportunity for profits to be made from the resulting difference. They also support arbitrage. Forwards Otherwise known as forward contracts, these contracts are non-standardized and occur between two parties who agree to buy or sell a particular aspect at a later (future) time at a price agreed on the current time. They are closely related to future contracts, but differ from spot contracts where the agreement and selling of the asset happens on the very same day or time (Ghosh & Clark 2004, p. 20). The party buying the underlying asset becomes the “long position” whereas the seller in the contract becomes the “short position.” Unlike futures that trade on centralized exchanges, forward contracts do not, so they are therefore considered OTC (over-the-counter) instruments. This makes their terms much easier to customize but the missing centralized setting (mediator) makes them more prone to default risks (Wikinvest 2012). These natures of forwards make them unpopular with retail investors, but are a favourite to big corporations. The price that the two parties agree on is called the delivery price, and is usually similar or equal to the forward price that is agreed upon before the delivery, at the time of making the contract. Before the control of the underlying instrument changes, its price has to be paid first, thus making this a form of buying or selling orders where the date or time of the trade differs from the value date, and in which the exchange happens to the securities. Similarly, to most derivatives, forwards act as securities, thus can reduce risks (Lloyd 2014). They can also act as a speculation means. In addition to these, they can allow for a party to benefit from the quality of the underlying instruments that are in time-sensitive, thus support arbitrage although these reduce, but not eliminate risks. Options Option contract, which also falls under derivative products refers to a contract that grants the owner (buyer) the freedom or the right to sell or buy an instrument or underlying asset at a specific strike price that has to be before, or on the date specified (Buckle & Thomson 2004, p. 258). On his part, the seller holds the corresponding mandate to complete or fulfil the contract’s transaction, but only if the owner executes the option. The owner (buyer) gives the seller a premium for the mentioned right. There exist two variations of options; put or call. A “put” option is one that conveys to the buyer the right and freedom to sell an asset at a specified price, whereas a “call” option is one that gives to the owner the right to purchase an asset at a specified price. In options, equity is emphasized and that leads to the use of a stock or ETF (exchange traded fund) or any product that is similar. When it comes to trade, options trade in units referred to as contracts in which each contract allocates to the owner or buyer one-hundred shares of the stock. The contracts have expiration dates upon which the options lose their values, thus cease to exist (Laukkanen 2007, p. 307). Options have two parts that are used in determining their values. These are; one, intrinsic value that refers to the variation between the strike price and the market value of the underlying instrument. The second is the time value that on its part relies on other factors that through a non-linear interdependence that is multi-variable define the discounted expected value of that variable at its expiry time. Options have standardized terms and undergo trade via the Chicago Board Options Exchange that is a clearinghouse. However, in the modern day finance, options also come with OTC properties. These can be written as contracts that are bilateral and customized between single sellers and buyers in which case both or either of them might be a market-maker or dealer (Contract-Law 2013). Similar to all other derivatives acting as securities, options in trading entail the risk of their values’ variation with time thus can act as speculations, risk hedging or assume arbitrage purposes. They, however differ from other traditional security models in that their returns vary in a non-linear manner with the value of whatever underlying factors are featured. This translates to the fact that all the risks that come with options tend to be more complex in understanding and predicting as well. Bibliography Buckle, MJ & Thompson, JL, 2004, The UK financial system: theory and practice, Manchester, Manchester University Press. Business Case Studies, 2014, Managing Trading Risk, The Times 100, Available at http://businesscasestudies.co.uk/london-international-financial-futures-and-options/managing-trading-risk/ways-of-managing-ris.html#axzz2te6pyVbl Contract-Law, 2013, Options Contracts Expalined, Laws. Com, Available at http://contract-law.laws.com/agreement/option-contracts Ghosh, D & Clark, E, 2004, Arbitrage, hedging, and speculation: the foreign exchange market, Westport, Conn, Quorum. Laukkanen, A 2007, Taxation of investment derivatives, Amsterdam, Netherlands, IBFD. Lloyd, H 2014, FRS 102: Part 3 Forward Contracts, Available at http://www.cch.co.uk/croner/jsp/Editorial.do?channelId=-646202&contentId=2924329&Failed_Reason=Session+not+found&Failed_Page=%2fjsp%2fEditorial.do&BV_UseBVCookie=No Sutcliffe, CMS 2006, Stock index futures, Aldershot, Hampshire, England, Ashgate. The Telegraph, 2014, Part2: Currency Derivatives: Forwards and Futures, The Telegraph. Co.uk. available at http://www.telegraph.co.uk/finance/2955696/Part-2-Currency-derivatives-forwards-and-futures.html Wikinvest, 2012, Forward Contract, Wikinvest.com, Available at http://www.wikinvest.com/wiki/Forward_Contract Read More