futures options
Walking Through Some Examples of Futures and
Options Contracts – Speculation and Hedging
As Dr. Cogley said in class the other day, sometimes futures contracts and options are hard to wrap your head around until you see them a few times. So I’ve written up some examples similar to those Dr. Cogley did in lecture, with a little more explanation about how we get the results that we do. But before we jump into that, we need to revisit our terms. 1. Forward contract: A buyer and a seller agree to a specific price/quantity exchange sometime in the future. Forward contracts are done between individuals (no intermediary), so all financial risk is born by those in the contract, which may result in some sort of risk premium factor being included.
2. Futures contract: Similar to forward contracts, but sold via exchange markets which act as intermediaries. By charging small transaction costs, the intermediaries cover possible default by either party, meaning those in the transaction no longer have to concern themselves with default risk.
3. Options contract: Similar to futures contracts, but without the binding effect – you pay a premium now to have the right to buy or sell in the future, but you don’t have to if you decide you don’t want to.
a. Call vs. put: call is the option to buy a security in the future at a set price, whereas a put is an option to sell at a set price.
b. European vs. American: European options specify a particular date of transaction, whereas American options can be exercised at any time up to the termination date.
c. “In the money”: an option is “in the money” when the price on the market is above the strike price for a call, or below the strike price for a put. Note that we don’t take into consideration the premium paid for the option when we talk about being “in the money”. All we care about is the price.
i. Strike price = the predetermined price for the transaction (also called the exercise price)
Now that that’s out of the way, let’s look at some
Options Contracts – Speculation and Hedging
As Dr. Cogley said in class the other day, sometimes futures contracts and options are hard to wrap your head around until you see them a few times. So I’ve written up some examples similar to those Dr. Cogley did in lecture, with a little more explanation about how we get the results that we do. But before we jump into that, we need to revisit our terms. 1. Forward contract: A buyer and a seller agree to a specific price/quantity exchange sometime in the future. Forward contracts are done between individuals (no intermediary), so all financial risk is born by those in the contract, which may result in some sort of risk premium factor being included.
2. Futures contract: Similar to forward contracts, but sold via exchange markets which act as intermediaries. By charging small transaction costs, the intermediaries cover possible default by either party, meaning those in the transaction no longer have to concern themselves with default risk.
3. Options contract: Similar to futures contracts, but without the binding effect – you pay a premium now to have the right to buy or sell in the future, but you don’t have to if you decide you don’t want to.
a. Call vs. put: call is the option to buy a security in the future at a set price, whereas a put is an option to sell at a set price.
b. European vs. American: European options specify a particular date of transaction, whereas American options can be exercised at any time up to the termination date.
c. “In the money”: an option is “in the money” when the price on the market is above the strike price for a call, or below the strike price for a put. Note that we don’t take into consideration the premium paid for the option when we talk about being “in the money”. All we care about is the price.
i. Strike price = the predetermined price for the transaction (also called the exercise price)
Now that that’s out of the way, let’s look at some