Question 4

Foreign exchange – convert euro to us dollar

Financial derivative (compare forward and future)

Hedging involves engaging in a financial transaction that reduces or eliminates risk

Forward contracts are agreements by two parties (buyer and seller) to engage in a financial
transaction at a future point in time.

The contract usually includes:

-The exact assets to be delivered by one party, including the location of delivery

-The price paid for the assets by the other party

-The date when the assets and cash will be exchanged

Forward contracts that are linked to debt instruments.

Pros -Flexible

Cons

Lack of liquidity: hard to find a counter-party and thin or non-existent secondary market

Subject to default risk—requires information to screen good from bad risk

Cannot do international transaction because only between 2 party, need find a suitable buyer to buy
ur amount of stock, if disaster happen then cannot deliver on time with low quality

Future market

Standardized Forward Contracts!- famous contract

Shopee/Lazada there is 1 place for seller to choose

Financial futures contracts is agreement between a buyer and a seller

Buyer agrees to take delivery of an asset at a specified price on a stated future date.

Seller agrees to make delivery of an asset at a specified price on a stated future date.

More standardize / Got platform(1centre communicate with all parties / Can track everyday / Can
look at the price like stock market / Can plan to sell / Much easier and flexible than forward market /
Must have money bfr invest (whole money will lose

- Exchange specifies certain standardize features of the contract- size, delivery date, location
and procedures.
- is traded on an exchange at any time until the delivery date.
- Clearinghouse: Guarantees that both parties to futures contracts satisfy their obligations
(Default risk?) (to control seller and buyer requires an initial deposit with the clearing house.
- Futures are more liquid: standardized contracts that can be traded
- Mark to market daily: avoids default risk
- Don’t have to deliver: cash netting of positions
 - Possible to gain from arbitrage opportunities

Arbitrage: The elimination of riskless profit opportunities in the futures market. It guarantees that
the price of a futures contract at expiration equals the price of the underlying asset to be delivered

Forward Contract Future Contract

Definition Agreement between two parties to Standardized contract traded in
buy or sell an asset at agreed price in exchange
future.
-Customized to customer needs Standardized, initial margin payment
-No need initial payment, used for required
hedging -used for speculation
Direct negotiation Quoted and traded on the exchange
not regulated Government regulated BURSA
(Commodity Future Trading)
The contracting parties Clearing house (give guarantee that
our investment would be a safe one)
High risk Low risk because it is government
regulated
Not guarantee of settlement until date Value the operation is marked to
of maturity market rates
Delivering the commodity Not necessarily mature by delivery of
commodity
Depends on transaction Standardized
Based on the transaction and Standardized
requirement

GRAPH – call and pull option

Advantage and disadvantage of option (16 and 17)

Call: a negotiable instrument that gives the holder (buyer) the right to buy the underlying security at
a specified price over a set period of time from the seller/maker/writer in exchange for a fee paid to
the seller/maker/writer

The buyer of the call option wants the price of the underlying assets to go up

The seller/maker/writer of the call option wants the price of the underlying assets to go down

If the price of the underlying assets goes up:

The buyer will buy the asset at the lower strike price from the seller/maker/writer and sell it at the
higher market price, making a profit

The seller will sell the assets at a price lower than the market price. If the seller does not already
own the assets, then the seller will have to purchase them at the higher market price

If the price of the underlying assets go down:

The buyer will let the call option expire worthless and lose the fee paid

The seller will keep the fee received and make a profit
 Put: a negotiable instrument that enables the holder (buyer) to sell the underlying security at a
specified price over a set period of time to the seller/maker/writer in exchange for a fee paid to the
seller/maker/writer

The buyer of the put option wants the price of the underlying assets to go down

The seller/maker/writer of the put option wants the price of the underlying assets to go up

If the price of the underlying assets goes down:

The buyer will buy the asset on the market at the lower price and force the seller/maker/writer to
buy the asset at the higher option price, making a profit

The seller will pay a price higher than the market price and will own expensive assets or will have to
sell them at a loss

If the price of the underlying assets go up:

The buyer will let the put option expire worthless and lose the fee paid

The seller will keep the fee received and make a profit

Option value ($)

Profit

500

Loss Breakeven point

Price of the stock ($)

 Option value ($)

Profit
Breakeven point
500

Loss

Price of the stock ($)

Differences Between Options and Futures Contracts

Both parties to a futures contract accept an obligation to transact, while only the options writer has
such an obligation. The option buyer has the rights to transact, hence has limited, known maximum
loss

The risk/return profile of an option position is asymmetric, while that of a futures position is
symmetric.

Buyer of futures contract gains when price increase and suffer losses when price drops, the opposite
holds for seller.

However for option buyer retains the benefits, which is reduced by the option price (upside
potential), while the losses limited (downside risk) while for seller the upside potential is limited up
to the option amount when buyer don’t exercise, and losses (down side risk is unlimited)

Option Futures
Stock option gives an investor the right but not Future contracts give parties an obligation to
the obligation to buyer sells a stock at an trade the underlying asset at an agreed upon
agreed upon price and date price and date
Upfront premium paid option buyer No advance payment except initial margin
Stock options are decaying assets. They lose The passage of time does not affect the value of
value as they approach expiration futures
Buyers have unlimited profit, but loss is limited Buyer and seller have unlimited profit and
to premium paid losses (more dangerous)