Page 140 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 8: Cash Planning

This process is called marking to market. When the futures transaction is closed, the firm reclaims Notes
the balance in its margin account.
A very common mistake regarding futures contracts is to think of the margin requirement as an
out-of-pocket transaction cost. Like a deposit on any purchase contract, the margin is eventually
applied to the purchase pries should the buyer take delivery. If the buyer cancels the contract by
taking an opposing position the margin is returned to the trader (less any losses and plus any
gains). Thus, the margin requirement is a partial payment for the final goods, not a transaction
cost.

Basics of Options on Interest Rate Futures Contracts

An option is a contract to purchase or sell something at a fixed price which may be exercised or
not at the buyer’s discretion. This is distinct from a future contract, which must be exercised,
unless the futures contract is canceled via an opposing transaction. In the case of a futures
contract, once the contract is canceled, the cost or benefit to the trader is the difference in price
between the original cost of the contract and it cancellation cost, which is the difference in the
trading price of the contract between when the trader went long and when he or she canceled via
the short (or vice versa). In the case of the option, the cost of the option does not count toward the
purchase price of the items in the contract, and the option does not have to be canceled it merely
expires.
Thus, for an option, the firm faces an initial out-of-pocket cost. But relative to the futures contract,
which locks in the future price of the commodity, the option offers greater flexibility. Since the
option need not be exercised, the firm’s costs are limited to the initial price of the option. If it is
not profitable to exercise the option the firm need not do so. However, if movement in the price
of the commodity on which the option is written turns out to be such that exercising the option
is profitable, the firm may make gains by exercising the option or by taking an opposing
position to the option and offsetting the positions. An option to sell an item for a fixed price over
a fixed period is called a put option. An option to buy an item for a fixed price over a fixed period
is called a call option.
The market prices of futures contracts on financial instruments and options on these contracts
depend on the market price of the underlying financial instrument. For futures contracts, while
the cash price of the instrument and the price of the instrument implied in the price future on this
instrument are always closely related, they may diverge when the futures contract is fat from
maturity. However, as the futures contract moves closer to maturity, the prices of the cash
purchase of the good and the price of the good implied by the price of the futures contract for the
good converge, until just before maturity the cash price of the good and the price implied by the
futures contract on this good are the same. This occurs because purchasing a futures contract
with a short time to maturity is virtually the same as purchasing the instrument itself.

For options on these futures contracts, the market price of the option depends on the relationship
between the market price of the instrument and the exercise price of the option.

Did u know? What is the exercise price of an option?
The exercise price is the price at which an option is executed. For a put option, it is the price
at which the instrument is sold to satisfy the option; for a call option it is the price at which
the instrument is bought.

If the exercise price of a put option on a financial future is greater than the current market
price of the future, then the value of the option must be at least the difference between the
prices. This is necessary because, if it were less, any investor could buy the future, exercise

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