anitha assignment

8/3/2019 Anitha Assignment

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Forward Contract

Definition:

A cash market transaction in which delivery of the commodity is deferred until after the contract has

been made. Although the delivery is made in the future, the price is determined on the initial trade

In finance, a forward contract or simply a forward is a non-standardized contract between two

parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to

a spot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the

underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the

future assumes a short position. The price agreed upon is called the delivery price, which is equal to

the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the instrument

changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the

same as the value date where the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at

which the asset changes hands on the spot date. The difference between the spot and the forward priceis the forward premium or forward discount, generally considered in the form of a profit, or loss, by

the purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange

rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the

underlying instrument which is time-sensitive.

Difference between Forward and Future Contract

However, it is in the specific details that these contracts differ. First of all, futures contracts are

exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other

hand, are private agreements between two parties and are not as rigid in their stated terms and

conditions. Because forward contracts are private agreements, there is always a chance that a partymay default on its side of the agreement. Futures contracts have clearing houses that guarantee the

transactions, which drastically lowers the probability of default to almost never.

Secondly, the specific details concerning settlement and delivery are quite distinct. For forward

contracts, settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-

market daily, which means that daily changes are settled day by day until the end of the contract.

Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on

the other hand, only possess one settlement date.

USES OF Forward Contract

Forward contracts offer users the ability to lock in a purchase or sale price without incurring anydirect cost. This feature makes it attractive to many corporate treasurers, who can use forward

contracts to lock in a profit margin, lock in an interest rate, assist in cash planning, or ensure supply of

a scarce resources. Speculators also use forward contracts to make bets on price movements of the

underlying asset.

Many corporations and banks will use forward contracts to hedge price risk by eliminating uncertainty

about prices. For instance, coffee growers may enter into a forward contract with Starbucks

(SBUX) to lock in their sale price of coffee, reducing uncertainty about how much they will be able to


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make. Starbucks benefits from contract because it is able to lock in their cost of purchasing coffee.

Knowing what price it will have to pay for its supply of coffee ahead of time helps Starbucks avoid

price fluctuations and assists in planning.

Risks of Forward Contract

Because no money exchanges hands initially, there is counterparty credit risk involved with forwardcontracts. Since you depend on the counterparty to deliver the asset (or cash if it is a cash settled

forward contract), if the counterparty defaults between the initial agreement date and delivery date,

you may have a loss. However, two conditions must apply before a party faces a loss:

1. The spot price moves in favor of the party, entitling it to compensation by the counterparty,and

2. The counterparty defaults and is unable to pay the cash difference or deliver the asset.

OPTIONS

In finance, an option is a derivative financial instrument that specifies a contract between two parties

for a future transaction on an asset at a reference price (the strike). The buyer of the option gains the

right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding

obligation to fulfil the transaction. The price of an option derives from the difference between the

reference price and the value of the underlyingasset (commonly a stock, a bond, a currency or

a futures contract) plus a premium based on the time remaining until the expiration of the option.

Other types of options exist, and options can in principle be created for any type of valuable asset.

An option which conveys the right to buy something at a specific price is called a call; an option

which conveys the right to sell something at a specific price is called a put. The reference price at

which the underlying asset may be traded is called the strike price or exercise price. The process of

activating an option and thereby trading the underlying at the agreed-upon price is referred to

as exercisingit. Most options have an expiration date. If the option is not exercised by the expiration

date, it becomes void and worthless.

In return for assuming the obligation, called writingthe option, the originator of the option collects a

payment, thepremium, from the buyer. The writer of an option must make good on delivering (or

receiving) the underlying asset or its cash equivalent, if the option is exercised.

An option can usually be sold by its original buyer to another party. Many options are created in

standardized form and traded on an anonymous options exchange among the general public, while

other over-the-counter options are customized ad hoc to the desires of the buyer, usually by

an investment bank.

CALL OPTION

A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and

the seller of this type of option The buyer of the call option has the right, but not the obligation to buy

an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller

of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or

"writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The

buyer pays a fee (called a premium) for this right.


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The buyer of a call option purchases it in the hope that the price of the underlying instrument will rise

in the future. The seller of the option either expects that it will not, or is willing to give up some of the

upside (profit) from a price rise in return for the premium (paid immediately) and retaining the

opportunity to make a gain up to the strike price (see below for examples).

Call options are most profitable for the buyer when the underlying instrument moves up, making the

price of the underlying instrument closer to, or above, the strike price. The call buyerbelieves it'slikely the price of the underlying asset will rise by the exercise date. The risk is limited to the

premium. The profit for the buyer can be very large, and is limited by how high the underlying

instrument's spot price rises. When the price of the underlying instrument surpasses the strike price,

the option is said to be "in the money".

The call writerdoes not believe the price of the underlying security is likely to rise. The writer sells

the call to collect the premium and does not receive any gain if the stock rises above the strike price.

PUT OPTION

A put orput option is a contract between two parties to exchange an asset, the underlying, at a

specified price, thestrike, by a predetermined date, the expiry ormaturity. One party, the buyer of the

put, has the right, but not an obligation, to sell the asset at the strike price by the future date, while theother party, the seller, has the obligation to buy the asset at the strike price if the buyer exercises the

option.

If the strike isKand maturity time is T, if the buyer exercises the put at a time t, the buyer can expect

to receive a payout ofK-S(t), if the price of the underlying S(t) at that time is less thanK. The

exercise tmust occur by time T; precisely what exact times are allowed is specified by the type of put

option. AnAmerican option can be exercised at any time before or equal to T; aEuropean option can

be exercised only at time T; aBermudan option can be exercised only on specific dates listed in the

terms of the contract. If the option is not exercised by maturity, it expires worthless. (Note that the

buyer will not exercise the option at an allowable date if the price of the underlying is greater thanK.)

The most obvious use of a put is as a type of insurance. In the protective put strategy, the investor

buys enough puts to cover their holdings of the underlying so that if a drastic downward movement of

the underlying's price occurs, they have the option to sell the holdings at the strike price. Another use

is for speculation: an investor can take a short position in the underlying without trading in it directly.

Puts may also be combined with other derivatives as part of more complex investment strategies, and

in particular, may be useful for hedging. Note that by put-call parity, a European put can be replaced

by buying the appropriate call option and selling an appropriate forward contract.

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