Page 75 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes
Table 5.2: Comparison between Futures and Options
Futures Options
Exchange traded, with novation Same as futures
Exchange defines the product Same as futures
Price is zero, strike price moves Strike price is fixed, price moves
Price is zero Price is always positive
Linear payoff Nonlinear payoff
Both long and short at risk Only short at risk

More generally, options offer “nonlinear payoffs” whereas futures only have “linear payoffs”.
By combining futures and options, a wide variety of innovative and useful payoff structures can
be created.

Task Consider a put option on 200 ounces of gold struck at USD 400. What will be the
put’s USD expiration value, if the market price of gold is USD 380 when the option expires?

Self Assessment

State whether the following statements are true or false:

14. In case of forward, both the buyer and the seller are under obligation to fulfil the contract.
15. Buying put options is buying insurance.
16. Trading in options is two- dimensional as the price of an option depends upon both the
price and the volatility of the underlying.

5.5 Index Derivatives

Index derivatives are derivative contracts which derive their value from an underlying index.
The two most popular index derivatives are index futures and index options. Index derivatives
have become very popular worldwide. Index derivatives offer various advantages and hence
have become very popular. Institutional and large equity-holders need portfolio-hedging facility.
Index-derivatives are more suited to them and more cost-effective than derivatives based on
individual stocks. Pension funds in the US are known to use stock index futures for risk hedging
purposes.
Index derivatives are a powerful tool for risk management for anyone who has portfolios
composed of positions in equity. Using index futures and index options, investors and portfolio
managers can hedge themselves against the risk of a downturn in the market when they should
so desire.

Example: For many investors the volatility associated with the budget might not be a
ride that they wish to bear. Today, in the absence of index derivatives, the investor has only one
alternative: to sell off equity, and move into cash or debentures, prior to the budget. Roughly a
month after the budget, once the budget-related volatility has subsided, these transactions could
be reversed, and the person would be back to the original equity exposure.

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