Lesson 01

Introduction to Forwards, Futures and Options

Learning Objectives

At the end of this lesson, students should be able to;

✓ Interpret what is a derivative.
✓ Understand the usage of derivatives.
✓ Broadly identify and discuss the classification of derivatives.
✓ Understand the basic terminologies behind Forwards, Futures and Options.
✓ Elaborate the mechanism involved in Forwards and Futures contracts.
✓ Compute the payoffs under Forwards and Futures contracts.

What are Derivatives?

A derivative is a financial instrument whose value depends on the values of other more
basic underlying variables on which it is written
Examples of Derivatives:
• Forward Contracts
• Futures Contracts
• Put Options
• Call Options
• Swaps

Usage of derivatives

• Hedging
Reducing the risk of adverse price movements in another asset.
Ex: An exporter who anticipates receiving foreign currency in a month can eliminate
exchangerate risk by using a short forward contract on the foreign currency.

• Speculation
The aim is to profit from anticipated market movements by taking a view on the future
direction of the market.

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 Forward Contracts

▪ Forward contract is an agreement to buy or sell an asset at a certain future time

for a certain price. The price can be contrasted with a spot contract, which is an
agreement to buy or sell an asset today.
Eg: On January 20, 2018, the treasurer of a corporation enters into a long
forward contract to buy £1 million in six months at an exchange rate of Rs. 220
Eg: On March 03, 2023, Mr. A enters into a short forward contract to sell 5000
bushels of wheat to Mr. B on July 03, 2023, at Rs. 100 per Kg.

▪ Forward contracts are particularly popular on currencies and interest rates.

▪ The asset specified in the contract is called the underlying asset or the underlying.
▪ The date specified in the contract on which the trade will take place is called the
maturity date of the contract
▪ The price specified in the contract for the trade is called the delivery price/forward
price in the contract if were negotiated today (The price at which delivery will be
made by the seller and accepted by the buyer). The forward price may be different
for contracts of different maturities

▪ Traded in the over-the-counter market-usually between two financial institutions or

between a financial institution and one of its clients.
▪ Customizable (Non-standardized) contracts where the terms of the contracts can
be tailored to the needs ofthe buyer and seller.
▪ Existence of a possible default risk for both parties. Each party takes the risk
that theother may fail to perform on the contract.

▪ One of the parties to a forward contract assumes a long position and agrees to buy
the underlying asset on a certain specified future date for a certain specified price.

▪ The other party assumes a short position and agrees to sell the asset on the same
date for the same price.

Long Position Buyer of the underlying asset

Short Position Seller of the underlying asset

▪ The parties to the forward contact has an obligation, neither party cannot enjoy a
right over the other.

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Payoffs from Forward Contracts

“Payoff is the profit or loss made by the two parties to the contract”.

Profit/Loss Profit/Loss

Price of
Price of
Underlying
Underlying
K at Maturity,
at Maturity, S K
T S
T

Long Position = (ST – K) Short Position = (K – ST)

▪ Forwards are zero-sum instruments - The profits made by the long come at the
expense of the short, and vice versa. The sum of the long and short is always zero
whereas the benefit to one side is exactly equal to the loss taken by the other.

Futures Contracts
▪ Like a Forward contract, Futures contract is an agreement to buy or sell an asset for a
certain price at a certain time.
▪ Traded on an exchange
▪ In futures contracts the exact delivery date is not specified, usually it is referred to by
its delivery month
▪ Available on a wide range of underlying’s
▪ Since the buyers and sellers do not meet, futures contracts must be standardized. This
standardization involves 3 main decisions such as standardized sets of contract sizes,
possible delivery options, quality or grade of the underlying.
Agreement to:
o Buy 100 oz. of gold @ US$900/oz. in December
o Sell £62,500 @ 2.0500 US$/£ in August
o Sell 1,000 bbl. of oil @ US$150/bbl. in October

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Closing Out Positions

▪ Majority of futures contracts do not lead to delivery. Most of them close out their
positions before the delivery period/maturity.
▪ Closing out a position means entering into the opposite type of trade from the original
one.
▪ For Ex. NY investor, bought (Long) a July corn futures contract on march 5, can close
out the position by selling (i.e., shorting) a July corn contract on April 20.
▪ The gain or loss is the difference between futures price between march 5 and April 20.

Margin requirements and Default risk

Future exchanges are exposed to the risk of default by investors. To mitigate this risk,
exchanges require investors to post margins. In practice, margin requirements are set
using statistical techniques that take in to account a range of factors, including possible
price movements and volatility changes over a day.

The Margin Procedure

This has three parts;
1. An investor entering into a futures contract is required to deposit a specified
amount of cash into an account called the margin account. The amount deposited
initially is called the initial margin.
2. At the end of each day, the balance in the margin account is adjusted to reflect the
investoR’s gains and losses from futures price movements over the day. This
process is called marking-to-market.
3. If the balance in the margin account falls below a critical minimum level
(maintenance margin), the investor receives a margin call requiring the account to
be topped up back to the level of the initial margin.

Futures Vs. Forwards

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 Options Contracts
▪ Option is an agreement to buy or sell an asset at a certain future time for a certain
price.
▪ The price in the contract is known as the exercise price or strike price (K).
▪ The date in the contract is known as the expiration date or maturity.
▪ Options can be either American or European; American options can be exercised at
any time up to the expiration date. European options can be exercised only on the
expiration date itself.
▪ Options are traded both on exchanges and in the over-the-counter market.
▪ There are two types of options:
o Call options
o Put options

Call Options Vs. Put Options

• An option to buy a certain asset (Stock) by a

Call Options certain date for a certain price (Strike price or
exercise price).

• An option to sell a certain asset (Stock) by a

Put Options certain date for a certain price (Strike price or
exercise price).

Options Market Participants

Long position of a call

Buyers/holders of calls
option
Call
Options
Short position of a call
Sellers/writers of calls
option
Options
Long position of a put
Buyers/holders of puts option
Put
Options
Short position of a put
Sellers/writers of puts option

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▪ There are two parties related to an option named: Holder (Buyer) and Writer (Seller or
Issuer) of an option.
▪ In options, the option holder has a right (power to decide whether to exercise the
option or not) and the option writer has an obligation.
▪ Buyers are referred to as having long positions; sellers are referred to as having short
positions. Selling an option is also known as writing the option.
▪ Further, it makes four types of participants in option markets.
o Buyers/holders of calls - the right to buy an asset at a predetermined (strike)
price
o Sellers/writers of calls - the obligation to sell an asset at a predetermined
(strike) price
o Buyers/holders of puts - the right to sell an asset at a predetermined (strike)
price
o Sellers/writers of puts - the obligation to buy an asset at a predetermined
(strike) price

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