FIN521 Chap.11 Options, Forwards and Futures
Options, Forwards and Futures
Four contracts, one separating question
The twelfth and thirteenth teaching weeks cover options markets and then forwards and futures, and the final examination rubric gives derivatives used in hedging and speculation thirty per cent, the joint largest criterion.
What defines these instruments is that the amount they pay out is governed by some other quantity altogether: a commodity quotation, a share or bond price, an interest rate, an index level. Hence the alternative name.
The question that separates all of them is who is obliged to do what: in a forward both sides must perform, while in an option only the seller must, and the buyer chooses.
The forward, and why it costs nothing today
Under a forward, one party undertakes to hand over an asset, or settle its cash equivalent, on a named future date at a figure fixed now and paid then.
The long position commits to buy and the short position commits to deliver, and nothing changes hands when the contract is struck. Both parties are bound whatever the price has done in between, which is what makes a forward a hedge rather than a bet: it removes uncertainty in both directions at once.
Plot the holder's gain against the maturity price and the result is a straight line through the agreed price, symmetric on both sides, and that symmetry is why neither side pays the other at inception.
Payoff is not profit
A call confers a choice rather than a duty: take the asset at the strike level at any time up to expiry. A put reverses the direction, letting the holder deliver instead.
Whichever is bought, the choice is paid for at the outset. Payoff is what the contract delivers at expiry and is never negative for the buyer; profit subtracts the premium and can be as negative as the premium. Break-even for a long call is the strike plus the premium and for a long put the strike minus it, and the strike itself is not the break-even, which is the mistake the arithmetic questions are built around.
The vocabulary of in, at and out of the money describes payoff only, so an option can be in the money and still be a loss.
Futures, and the same contract used two ways
A futures contract does a forward's economic job with different plumbing: standardised terms so that it trades on an exchange, a clearing house between the two sides so that neither is exposed to the other's failure, and daily marking to market so that gains and losses settle in cash against a margin account.
That changes when the cash moves rather than the total gain, so a holder who is right in the end and wrong for three months must fund three months of losses first. Hedging and speculating, finally, are not properties of an instrument. A producer who will own the asset and sells a forward removes a risk already held; a trader with no exposure who sells the same forward creates one.
What this chapter covers
- 01
Contingent claims and what their payoffs depend on
- 02
Who is obliged in a forward and who may choose in an option
- 03
Why a forward costs nothing at inception
- 04
Calls and puts, strike price and premium
- 05
Payoff against profit, and the two break-even prices
- 06
In, at and out of the money as payoff vocabulary
- 07
The writer's mirror position and the uncapped loss
- 08
Futures as forwards with standardisation and daily settlement
- 09
Hedging against speculation, and the fact that reclassifies a position
Build a profit profile and find both break-evens
- 2Write the two payoff expressions before substituting anything.
- 4Give the profit on each position at the three prices.
- 4State both break-evens and the bounds on each position.
Key terms
- Contingent Claim
- A second label for a derivative, used because what it pays turns on some other asset, rate or index rather than on a promise by an issuer.
- Forward Contract
- A mutual undertaking to exchange an asset, or its cash equivalent, on a named date at a figure fixed in advance; it binds each side and requires no payment when struck.
- Long Position
- The side of a forward or futures contract that commits to purchase the asset on the delivery date.
- Call Option
- A contract granting a choice rather than a duty to take the asset at the strike level, exercisable at any point up to expiry.
- Put Option
- A contract granting a choice rather than a duty to deliver the asset at the strike level, exercisable at any point up to expiry.
- Premium
- The price the buyer of an option pays up front for the right the contract grants, and the buyer's maximum possible loss.
- Break Even Price
- The expiry price at which an option position recovers its premium exactly, being the strike plus the premium for a call and the strike minus it for a put.
- Marking To Market
- The daily settlement of gains and losses on a futures position against a margin account, which changes when cash moves rather than the total outcome.
- Clearing House
- The institution standing between the two sides of an exchange-traded contract so that neither is exposed to the other's failure.
- Hedging
- Taking a derivative position that offsets an exposure already held, as distinct from speculation, which creates an exposure that did not exist.
Options, Forwards and Futures FAQ
What is the difference between payoff and profit?
Payoff is what the contract delivers at expiry and for a buyer it is never negative, because an option that finishes out of the money is simply abandoned. Profit subtracts the premium paid at the start, so it can be negative by as much as that premium and no more.
Keeping them apart matters because questions routinely set the expiry price between the strike and the break-even, where the position is in the money and still losing, and only an answer that has kept the two concepts separate handles that case.
Why would anyone write an option?
For the premium, which the writer keeps if the option expires worthless, and that is a high-probability outcome for many contracts. The exposure is the mirror of the buyer's: the writer of a call has limited gain and a loss that grows without limit as the underlying rises, because delivery must be made at the strike whatever the market price.
That asymmetry is why brokers restrict uncovered writing in the same way they restrict short selling, and it should be named whenever a question offers writing as a strategy.
If futures and forwards produce the same total gain, why choose between them?
Because of when the cash moves and who bears the credit risk. A futures position settles daily against a margin account, so a holder who is ultimately right but temporarily wrong must fund the interim losses or be closed out. A forward accumulates to maturity and leaves each side exposed to the other's failure, but it can be written for any quantity and date, which makes it a more precise hedge.
Precision against liquidity and credit protection is the trade.
Exam move
Draw the four basic profit profiles from memory, long call, long put, short call and short put, and mark the break-even on each before checking them. Then take one share you follow, invent a plausible strike and premium, and write out the profit at five expiry prices, because the arithmetic only becomes fast once the shape is automatic.
Finish by classifying three real positions as hedging or speculation and naming the fact that would change each classification.
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