BASICS OF

FORWARDS, FUTURES
AND OPTIONS
Derivatives
A derivative is asecuritywith a price that is
dependent upon or derived from one or more
underlyingassets.
The derivative itself is a contract between two
or more parties based upon the asset or
assets. Its value is determined by fluctuations
in the underlying asset. The most common
underlying assets
includestocks,bonds,commodities,currencies
,interest ratesandmarket indexes.
Exchange-traded vs. over-the-counter
derivatives

Like their underlying cash instruments,

some derivatives are traded on
established exchanges (the New York
Stock Exchange, the French CAC or
the Chicago Board of Trade).
These are referred to asexchange-
tradedderivatives and, generally, they
havehighly standardized terms and
features.The advantage of exchange-
traded derivatives is that regulated
exchanges provide clearing and regulatory
safeguards to investors.
Cont
Many other derivative instruments, including
forwards, swaps and exotic derivatives, are
tradedoutside of the formal, established
exchanges. These are over-the-counteror OTC-
traded derivatives
They can be created by any two counterparties with

highly flexible terms and a nearly infinite number of

underlying assets or asset combinations.
In the OTC derivatives market, large financial

institutions serve as derivatives dealers,

customizing derivatives for the specific needs of
clients.
Risks

Exchange Traded = Standardizes =

Market Risk
OTC Traded = Customized = Market
Risk + Counterparty Risk
What is a 'Forward Contract'

A forward contract is a customized

contract between two parties to buy or sell
an asset at a specified price on a future
date.
A forward contract can be used for
hedging or speculation, although its non-
standardized nature makes it particularly
apt for hedging.
Unlike standardfutures contracts, a
forward contract can be customized to any
commodity, amount anddelivery date.

Cont..
Forward contracts do not trade on a
centralized exchange and are therefore
regarded as over-the-counter (OTC)
instruments.
While theirOTCnature makes it easier to
customize terms, the lack of a centralized
clearinghouse also gives rise to a higher
degree ofdefault risk.
As a result, forward contracts are not as easily
available to theretail investorasfutures
contracts.
BREAKING DOWN 'Forward Contract'

Consider the following example of a forward

contract.
Assume that an agricultural producer has 2
million bushels of corn to sell six months
from now, and is concerned about a potential
decline in the price of corn. It therefore enters
into a forward contract with itsfinancial
institutionto sell 2 million bushels of corn
at a price of $4.30 per bushel in six months,
with settlement on acash basis.
In six months, thespot priceof corn has three possibilities:

It is exactly $4.30 per bushel: In this case,

nomoniesare owed by the producer or financial
institution to each other and the contract is closed.
It is higherthan the contract price, say $5
per bushel: The producer owes the institution $1.4
million, or the difference between the current spot
price and the contracted rate of $4.30.
It is lower than the contract price, say $3.50
per bushel: The financial institution will pay the
producer $1.6 million, or the difference between
the contracted rate of $4.30 and the current spot
price.
About Forwards
The market for forward contracts is huge, since
many of the worlds biggest corporations use
it tohedgecurrency andinterest rate risks.
However, since the details of forward contracts
are restricted to the buyer and seller, and are not
known to the general public, the size of this
market is difficult to estimate.
The large size and unregulated nature of the
forward contracts market means that it may be
susceptible to a cascading series ofdefaultsin
the worst-case scenario.
While banks and financial corporations
mitigate this risk by being very careful in their
Cont.
Another risk that arises from the non-standard nature of
forward contracts is that they are only settled on
thesettlement date, and are not marked-to-market
like futures.
What if theforward ratespecified in the contract
diverges widely from thespot rateat the time of
settlement?
In this case, the financial institution that originated the
forward contract is exposed to a greater degree of risk
in theevent of defaultor non-settlement by the client
than if the contract were marked-to-market regularly.
Delivery Date
1. The final date by which theunderlying
commodityfor a contractmust be
delivered in order for the terms of the
contract to be fulfilled.
2. Thematurity dateof acurrency forward
contract.
BREAKING DOWN 'Delivery Date'

All futures and forward contracts have a

delivery date upon which the underlying
must be transferred to thecontract
holder if he or she holds the contract
until maturity instead of offsetting it.
Forward Exchange Contract
A forward exchange contract is a special type of
foreigncurrencytransaction.
Forward contractsare agreements between
two parties to exchange two designated
currencies at a specific time in the future.
These contracts always take place on a date
after the date that the spot contract settles and
are used to protect the buyer from fluctuations
in currency prices.
Forward Market
A forward market is an over-the-counter
marketplace that sets the price of afinancial
instrumentor asset for future delivery.
Forward markets are used for trading a range of
instruments, but the term is primarily used with
reference to the foreign exchange market.
It can also it can also apply to markets for
securitiesand interestrates as well
ascommodities.
Example: Forward
Contracts
Let's assume that you have just taken up sailing and like
it so well that you expect you might buy your own
sailboat in 12 months. Your sailing buddy, John, owns a
sailboat but expects to upgrade to a newer, larger model
in 12 months. You and John could enter into a forward
contract in which you agree to buy John's boat for
$150,000 and he agrees to sell it to you in 12 months for
that price. In this scenario, as the buyer, you have
entered a long forward contract. Conversely, John, the
seller will have the short forward contract.At the end of
one year, you find that the current market valuation of
John's sailboat is $165,000. Because John is obliged to sell
his boat to you for only $150,000, you will have
effectively made a profit of $15,000. (You can buy the
boat from John for $150,000 and immediately sell it for
$165,000.) John, unfortunately, has lost $15,000 in
potential proceeds from the transaction.
What are Futures?

Futures contracts areagreementsto

trade an underlying asset at a future
date at a pre-determined price. Both the
buyer and the seller are obligated to
transact on that date. Futures are
standardized contracts traded on an
exchange where they can be bought and
sold by investors.
Video
Difference between Forwards and Futures

The main differentiating feature between

futures and forward contracts that
futures are publicly traded on an
exchange while forwards are
privately traded results in several
operational differences between them.
This comparison examines differences
like counterparty risk, daily centralized
clearing andmark-to-market, price
transparency, and efficiency.
Comparison chart

Forward Futures
Contract Contract
Definition A forward contract is A futures contract is a
an agreement standardized
between two parties contract, traded on a
to buy or sell an futures exchange, to
asset (which can be buy or sell a certain
of any kind) at a pre- underlying
agreed future point in instrument at a
time at a specified certain date in the
price. future, at a specified
price.
Structure & Purpose Customized to Standardized. Initial
customer needs. margin payment
Usually no initial required. Usually
payment required. used for speculation.
Usually used for
Cont.

Negotiated directly by Quoted and traded on

Transaction method
the buyer and seller the Exchange

Government
regulated market (the
Commodity Futures
Market regulation Not regulated
Trading Commission
or CFTC is the
governing body)

Institutional The contracting

Clearing House
guarantee parties

Risk High counterparty risk Low counterparty risk

Cont..
Guarantees No guarantee of Both parties must
settlement until deposit an initial
the date of guarantee
maturity only the (margin). The
forward price, value of the
based on the spot operation is
price of the marked to market
underlying asset is
rates with daily
paid settlement of
profits and losses.
Contract Maturity Forward contracts Future contracts
generally mature may not
by delivering the necessarily mature
commodity. by delivery of
commodity.
Expiry date Depending on the Standardized
transaction
 Cont..
Method of pre- Opposite contract Opposite contract
termination with same or on the exchange.
different
counterparty.
Counterparty risk
remains while
terminating with
different
counterparty.
Contract size Depending on the Standardized
transaction and the
requirements of
the contracting
parties.
Market Primary & Primary
Secondary
Trade Procedure

In a forward contract, the buyer and seller are private parties

who negotiate a contract that obligates them to trade an
underlying asset at a specific price on a certain date in the
future. Since it is a private contract, it is not traded on an
exchange but over the counter.
No cash or assets change hands until the maturity date of the
contract. There is usually a clear "winner" and "loser" in
forward contracts, as one party will profit at the point of
contract maturity, while the other party will take a loss.
For example, if the market price of the underlying asset is
higher than the price agreed in the forward contract, the seller
loses. The contract may be fulfilled either via delivery of the
underlying asset or a cash settlement for an amount equal to
the difference between the market price and the price set in
the contract
Cont..
The terms that are standardized include price,
date, quantity, trading procedures, and place of
delivery (or terms for cash settlements).
Only futures for assets standardized and listed
on the exchange can be traded.
On the futures exchange, there are standard
contracts for such situations say, a standard
contract with the terms of "1,000 kg of corn for
$0.30/kg for delivery on 10/31/2015." here are
even futures based on the performance of
certainstock indices, like the S&P 500
PHYSICAL DELIVERY VS. CASH SETTLEMENT
Physical Delivery
Refers to an option or futures contract that
requires the actual underlying asset to be
delivered on the specified delivery date,
rather than being traded out with
offsetting contracts. Most derivatives are
not actually exercised, but are traded out
before their delivery dates.
However, physical delivery still occurs
with some trades: it is most common with
commodities, but can also occur with
other financial instruments.Settlement by
physical delivery is carried out by clearing
Cont..
Promptly after the last day of trading, the regulated
exchange's clearing organization will report a
purchase and sale of the underlying asset at the
previous day's settlement price (also referred to as
the "invoice price").
Traders who hold a short position in a physically

settled security futures contract to expiration are

required to make delivery of the underlying asset.
Those who already own the assets may tender them
to the appropriate clearing organization. Traders
who do not own assets are obligated to purchase
them at the current price.
Cont
Exchanges specify the conditions of delivery for the
contracts they cover. Acceptable locations for delivery (in
the case of commodities or energies) and requirements as
to the quality, grade or nature of the underlying asset to be
delivered are regulated by the exchanges.
For example, only certainTreasury bondsmay be delivered
under the Chicago Board of Trade's Treasury bond future.
Only certain growths of coffee may be delivered under the
Coffee, Sugar and Cocoa Exchange's coffee future.
In many commodity or energy markets, parties want to
settle futures by delivery, but exchange rules are too
restrictive for their needs. For example, the New York
Mercantile Exchange requires that natural gas be delivered
only at the Henry Hub in Louisiana, a location that may not
be convenient for all futures traders.
What is a 'Cash Settlement'

A cash settlement is a settlement method used in

certain futures and options contracts where, upon
expiration or exercise, the seller of thefinancial
instrumentdoes not deliver the actual underlying
asset but instead transfers the associatedcash
position
For sellers not wishing to take actual possession
of the underlyingcash commodity, a cash
settlement is a more convenient method of
transacting futures andoptions contracts.
For example, the purchaser of a cash-settled
cotton futures contract is required to pay the
difference between thespot priceof cotton and
BREAKING DOWN 'Cash Settlement'

Futures and options contracts are derivative

instruments that have values based on an
underlying asset.
The asset can be an equity or a commodity.
When a futures contract or options contract is
expired or exercised, the conceptual recourse is
for the holder of the contract to deliver the
physical commodity or transfer the actual
shares of stock.
This is known as physical delivery and is much
more cumbersome than a cash settlement.
Cont..
If an investor goes short on a futures
contract for $10,000 worth of silver, for
example, it is inconvenient at the end of
the contract for the holder to physically
deliver silver to another investor.
To circumvent this, futures and options
contracts can be conducted with a cash
settlement, where, at the end of the
contract, the holder of the position is
either credited or debited the difference
between the initial price and the final
settlement.
Cont..
Futures contracts are taken out by
investors who believe a commodity
will increase or decrease in price in
the future. If an investor goes short a
futures contract for wheat, he is
assuming the price of wheat will
decrease in the short term. A
contract is initiated with another
investor who takes the other side of
the coin, believing wheat will
An Example of a Cash Settlement

In this example, an investor goes short on a

futures contract for 100 bushels of wheat for a
total of $10,000. This means at the end of the
contract, if the price of 100 bushels of wheat
drops to $8,000, the investor is set to earn
$2,000. However, if the price of 100 bushels of
wheat increases to $12,000, the investor loses
$2,000.
Conceptually, at the end of the contract, the 100
bushels of wheat are "delivered" to the investor
with the long position. However, to make things
easier, a cash settlement can be used. If the
price increases to $12,000, the short investor is
required to pay the difference of $12,000 -
Example: Settling a Forward Contract

Let's return to our sailboat example from the first part of this
section. Assume that at the end of 12 months you are a bit
ambivalent about sailing. In this case, you could settle your
forward contract with John in one of two ways:
Physical Delivery - John delivers that sailboat to you and you
pay him $150,000, as agreed.
Cash Settlement - John sends you a check for $15,000 (The
difference between your contract's purchase price of $150,000
and the sail boat's current market value of $165,000).
The same options are available if the current market price is
lower than the forward contract's settlement price. If John's
sailboat decreases in value to $135,000, you could simply pay
John $15,000 to settle the contract, or you could pay him
$150,000 and take physical possession of the boat. (You would
still suffer a $15,000 loss when you sold the boat for the current
price of $135,000.)
OPTIONS
What is an 'Option'
An option is a financial derivative that
represents a contract sold by one party (the
option writer) to another party (the option
holder). The contract offers the buyer the
right, but not the obligation, to buy (call) or
sell (put) a security or otherfinancial assetat
an agreed-upon price (the strike price) during
a certain period of time or on a specific date
(exercise date).
BREAKING DOWN 'Option'

Options are extremely versatilesecurities.

Traders use options to speculate, which is
a relatively risky practice, while hedgers
use options to reduce the risk of holding
an asset. In terms of speculation, option
buyers and writers have conflicting views
regarding the outlook on the performance
of anunderlying security.
Video
Say, for example,
You discover a house that you'd love to
purchase. Unfortunately, you won't have
the cash to buy it for another three
months. You talk to the owner and
negotiate a deal that gives you an option
to buy the house in three months for a
price of $200,000. The owner agrees, but
for this option, you pay a price of $3,000.
Now, consider two theoretical situations
that might arise:

1. It's discovered that the house is actually the true

birthplace of Elvis! As a result, the market value of
the house skyrockets to $1 million. Because the
owner sold you the option, he is obligated to sell
you the house for $200,000. In the end, you stand
to make a profit of $797,000 ($1 million -
$200,000 - $3,000).
2. While touring the house, you discover not only
that the walls are chock-full of asbestos, but also
that the ghost of Henry VII haunts the master
bedroom; furthermore, a family of super-
intelligent rats have built a fortress in the
basement. Though you originally thought you had
found the house of your dreams, you now
Cont
This example demonstrates two very important
points. First, when you buy an option, you have
a right but not an obligation to do something.
You can always let the expiration date go by, at
which point the option becomes worthless. If
this happens, you lose 100% of your
investment, which is the money you used to
pay for the option.
Second, an option is merely a contract that
deals with an underlying asset. For this reason,
options are called derivatives, which means an
optionderivesits value from something else. In
our example, the house is the underlying asset.
Video
Call Option

Call options give the option to buy at certain

price, so the buyer would want the stock to go
up. Conversely, the option writer needs to
provide the underlying shares in the event that
the stock'smarket priceexceeds the strike due
to the contractual obligation. An option writer
who sells acall optionbelieves that the
underlying stock's price will drop relative to the
option'sstrike priceduring the life of the option,
as that is how he will reap maximum profit.
Cont..
This is exactly the opposite outlook of the
option buyer. The buyer believes that the
underlying stock will rise; if this happens, the
buyer will be able to acquire the stock for a
lower price and then sell it for a profit.
However, if the underlying stock does not
close above the strike price on the expiration
date, the option buyer would lose the
premium paid for the call option.
Video
Put Option

Put options give the option to sell at a certain

price, so the buyer would want the stock to go
down. The opposite is true for put option writers.
For example, a put option buyer is bearish on
the underlying stock and believes its market
price will fall below the specified strike price on
or before a specified date. On the other hand, an
option writer who shorts a put option believes the
underlying stock's price will increase about a
specified price on or before the expiration date.
Cont..
If the underlying stock's price closes above the
specified strike price on the expiration date, the
put option writer's maximum profit is achieved.
Conversely, a put option holder would only
benefit from a fall in the underlying stock's price
below the strike price. If the underlying stock's
price falls below the strike price, the put option
writer is obligated to purchase shares of the
underlying stock at the strike price.
Video
Participants in the
Options Market
There are four types of participants in options
markets depending on the position they take:
1. Buyers of calls

2. Sellers of calls

3. Buyers of puts

4. Sellers of puts

People who buy options are called holders and

those who sell options are calledwriters;
furthermore, buyers are said to have long
positions, and sellers are said to have short
positions.
Here is the important distinction between
buyers and sellers:

Call holders and put holders (buyers) are

not obligated to buy or sell. They have the
choice to exercise their rights if they
choose.
Callwritersand put writers (sellers),
however, are obligated to buy or sell. This
means that a seller may be required to
make good on a promise to buy or sell.
Physical Delivery Vs Cash Settlement

Video