FOREX

Introduction

The foreign exchange market is a crucial part of the global economy. Various instruments are
used in forex trading, such as forwards, futures, options, and swaps.

Forex market basics

The foreign exchange market (also referred to as the forex or currency market) is the
marketplace for exchanging currencies between all stakeholders such as governments, central
and commercial banks, firms, forex dealers, brokers and individuals. Such players can use the
market for trading, hedging and speculating in currencies as well as obtaining credit.

How are exchange rates determined?

Currencies are always traded in pairs e.g.: USD-EUR, USD-INR etc. The relationship between
the currencies is given by the formula:

Base currency / Quotation Currency = Value

For example, if the base currency is USD and the quotation currency is INR then the value
would be roughly around 79 as the rupee is trading at around INR 79 per USD.

Now exchange rates are determined by various factors depending on whether the currencies in
question have “free float” or “fixed float”.

1. Free floating currencies are those whose value depends solely on the demand and
supply of the currency relative to other currencies.

2. Fixed floating currencies are those whose value is fixed by the government or the
central bank, sometimes by pegging it to a standard. For example, the Russian Ruble
was recently pegged to gold at 5000 rubles per gram of gold.

Types of Forex Market

There are 5 types of currency markets in India – spot, forward, futures, options and swaps.

The spot market is the marketplace for currency trading at real-time exchange rates.

On the other hand, forward markets deal in over-the-counter (OTC) forward contracts. Forward
contracts are agreements between parties to exchange a particular quantity of currency pair at
a specific rate and on a given date.
They help in hedging currency risks i.e. the risk of changing values of currency assets due to
fluctuations in currency exchange rates. However, forward markets do not have a central
exchange for their operations. Therefore:

1. They are highly illiquid (hard to find buyers or sellers randomly)

2. They usually do not require any collateral and thus have counterparty risk i.e. risk of
parties not following through with an agreement

The futures markets are basically forward markets, but with centralised exchanges like the
NSE. Therefore, they have higher liquidity and lower counterparty risk than forward
markets. Currency futures or FX futures or currency derivatives are available on the NSE on
INR and four currencies viz. US Dollars (USD), Euro (EUR), Japanese Yen (JPY) and Great
Britain Pound (GBP). Cross Currency Futures & Options contracts on EUR-USD, USD-JPY
and GBP-USD are also available for trading in the currency derivatives segment. Since all
transactions are publicly available and settled in cash, it is easier to trade, speculate and perform
arbitrage in the futures market.

The options market allows traders the right to buy/sell currency at a specified price on a
specified date through a central exchange such as the NSE. The currencies available are the
same as that of the NSE currency futures market.

Currency swaps are agreements between two parties to exchange a principal and interest
amount in different currencies only to be re-exchanged at a specific later date. At least one of
the interest rates in the agreement is fixed.

Special features of the forex market

 The forex market has a higher degree of leverage than other markets (such as the stock
market). Leverage is the loan given by a broker to a trader to allow the trader to invest
in greater quantities than otherwise. However, higher leverage also means risk of higher
losses.

 There are no central clearing houses that oversee international currency trade. However,
the central banks and governments usually regulate the forex trade.
  The forex market has a large variety of currencies and is open 245 as it is an
international market. The market opens on Sunday 5pm EST and closes on Friday 5pm
EST. Therefore, there is a wider range of opportunities for trade. However, the risk
also increases as an international incident in some far-away time-zone might devalue
your currency assets while you are sleeping.

 There are fewer commissions and fees to be paid in currency trading.

Currency market in India

As per the RBI, OTC and spot markets are dominant in the Indian currency market where
around USD 33 billion was traded daily in 2019. Currency futures are traded on exchanges
such as NSE, BSE, and MCX-SX.

Trends in the forex market

The USD is the most traded currency in the world (being a part of over 85% of trades), which
allows it to act as an unofficial reserve currency among other countries. The Euro and Yen
come as distant second and third. As per a BIS report, trading in currency globally reached $6.6
trillion per day in April 2019.
 Value for money (VFM) and the 3 E’s

Introduction

A significant number of NFPs are funded from the public purse, the lack of clear financial
performance measures has been seen as a particular problem. It is argued that the public are
entitled to reassurance that their money (in the form of taxes for public sector organisations or
donations for charities) is being properly spent. In addition, the complex mix of objectives with
no absolute priority has also led to concern that the money may be being directed towards the
wrong ends. These issues, along with a growth in the perceived need for greater accountability
among public officials, led to the development of the concept of evaluating VFM in public
sector organisations. The principles developed are now widely applied in NFPs.

VFM can be defined as ‘achieving the desired level and quality of service at the most
economical cost’.

Systems analysis

A more detailed analysis of what is meant by VFM can be achieved by viewing the organisation
as a system set up to achieve its objectives by means of processing inputs into outputs.

The organisation of a system

The three E’s

Assessing whether the organisation provides value for money involves looking at all
functioning aspects of the organisation. Performance measures have been developed to permit
evaluation of each part separately.

Economy: Minimising the costs of inputs required to achieve a defined level of output.
Efficiency: Ratio of outputs to inputs – achieving a high level of output in relation to the
resources put in (input driven) or providing a particular level of service at reasonable input cost
(output driven)

Effectiveness: Whether outputs are achieved that match the predetermined objectives.

Use of the 3 Es as a performance measure and a way to assess VFM is a key issue that relate
to NFPs and public sector organisations.

Known as the 3 Es these measures are fundamental to an understanding of VFM. An

organisation achieving economy, efficiency and effectiveness in each part of the system is
considered to be providing good VFM.

Public sector organisations are subject to regular VFM (or best value) reviews and the results
have important impacts on future plans and funding decisions.

Economy

Acquiring resources of appropriate quality and quantity at the lowest cost. Note that whilst
obtaining low prices is an important consideration it is not the only one. Achieving true
economy will include ensuring the purchases are fit for purpose and meet any predetermined
standards.
Efficiency

Maximising the useful output from a given level of resources, or minimising the inputs required
to produce the required level of output. Some public services fall within the first definition as
they try to provide as much of a service as possible with strictly limited resources and few
opportunities to generate further income sources. This is defined as ‘input-driven’ efficiency.
This would include services such as library provision.

However, in many areas there is a statutory obligation to provide a particular standard of

service, for example prison services, which cannot be significantly reduced or withdrawn. In
this case, the obligation is to provide the service at a reasonable cost and is known as ‘output-
driven’ efficiency.

In both areas, the key consideration is whether the resources used were put to good use and the
methods and processes carried out represent best practice.

Effectiveness

Ensuring that the output from any given activity is achieving the desired result. For example,
the cheapest site on which to build and run a sports centre may be a disused brownfield site on
the edge of town. However, if the council’s objectives included reduction in car use and
accessible opportunities for health improvement, then the output of the building process – the
sports centre, even if built economically and efficiently, would not be considered effective as
it failed to meet the stated objectives
Payback method of appraisal

The payback period is the time a project will take to pay back the money spent on it. It is based
on expected cash flows and provides a measure of liquidity.

Decision rule:

 only select projects that pay back within the specified time period
 choose between options on the basis of the fastest payback Constant annual cash flows

Payback period = initial investment / annual cash flow.

A project is expected to have the following cash flows:

Year Cash flow $000

0 (1900)
1 300
2 500
3 600
4 800
5 500
What is the expected payback period?

Year Cashflow Cumulative Cashflow

0 (1900) (1900)
1 300 (1600)
2 500 (1100)
3 600 (500)
4 800 300
5 500 800

In the table above a column is added for cumulative cash flows for the project to date. Figures
in brackets are negative cash flows.

Each year’s cumulative figure is simply the cumulative figure at the start of the year plus the
figure for the current year. The cumulative figure each year is therefore the expected position
as at the end of that year.
Payback is between the end of Year 3 and the end of Year 4 – that is during Year 4. This is the
point at which the cumulative cash flow changes from being negative to positive. If we assume
a constant rate of cash flow throughout the year, we could estimate that payback will be three
years plus ($500/800) of Year 4. This is because the cumulative cash flow is minus $500 at the
start of the year and the Year 4 cash flow would be $800.

$500/800 = 0.625

Therefore, payback is after 3.625 years.

Payback in years and months is calculated by multiplying the decimal fraction of a year by 12
months. In this example, 0.625 years = 7.5 months (0.625 × 12 months), which is rounded to 8
months. So therefore, payback occurs after 3 years 8 months.

Net Present Value

To appraise the overall impact of a project using DCF techniques involves discounting all the
relevant cash flows associated with the project back to their PV. If we treat outflows of the
project as negative and inflows as positive, the NPV of the project is the sum of the PVs of all
flows that arise as a result of doing the project.

The NPV represents the surplus funds (after funding the investment) earned on the project,
therefore:

 if the NPV is positive – the project is financially viable

 if the NPV is zero – the project breaks even (just returning enough money to cover the
funding costs)
 if the NPV is negative – the project is not financially viable
 if the company has two or more mutually exclusive projects under consideration it
should choose the one with the highest NPV
 the NPV gives the impact of the project on shareholder wealth.

There are a number of alternative terms used to refer to the rate a firm should use to take
account of the time value of money:

 cost of capital
 discount rate

Whatever term is used, the rate of interest used for discounting reflects the cost of the finance
that will be tied up in the investment.
An organisation is considering a capital investment in new equipment. The estimated cash
flows are as follows.

Year Cash Flow $

0 (240000)
1 80000
2 120000
3 70000
4 40000
5 20000
The company’s cost of capital is 9%.

Calculate the NPV of the project to assess whether it should be undertaken

Year Cashflow Discount factor @ 9% Present Value

0 (240000) 1.0 (240000)
1 80000 0.917 73360
2 120000 0.842 101040
3 70000 0.772 54040
4 40000 0.708 28320
5 20000 0.650 13000
Net Present Value 29760

The PV of cash inflows exceeds the PV of cash outflows by $29,760, which means that the
project will earn a DCF return in excess of 9%, i.e. it will earn a surplus of $29,760 after paying
the cost of financing. It should therefore be undertaken.
 PROFITABILITY INDEX

Investment = Rs.40,000

Life of the Machine = 5 Years

Year CFAT
1 18000
2 12000
3 10000
4 9000
5 6000
Calculate Net present value at 10% and PI:

YEAR CFAT PV@10% PV

1 18000 0.909 16362
2 12000 0.827 9924
3 10000 0.752 7520
4 9000 0.683 6147
5 6000 0.621 3726
Total present value 43679

Total Present Value - 43679

Initial Investment - 40000

NPV - 3679

PI = 43679/40000 = 1.091 > 1 ⇒ Accept the project

 INTERNAL RATE OF RETURN

A business undertakes high-risk investments and requires a minimum expected rate of return
of 17% pa on its investments. A proposed capital investment has the following expected cash
flows:

Year $
0 (50,000)
1 18,000
2 25,000
3 20,000
4 10,000

(1) Calculate the NPV of the project if the cost of capital is 15%.

(2) Calculate the NPV of the project if the cost of capital is 20%.

(3) Use the NPVs you have calculated to estimate the IRR of the project.

(4) Recommend, on financial grounds alone, whether this project should go ahead.

Year Cash flow DF at 15% PV at 15% DF at 20% PV at 20%

0 (50000) 1.000 (50000) 1.000 (50000)
1 18000 0.870 15650 0.833 14994
2 25000 0.756 18900 0.694 17350
3 20000 0.658 13160 0.579 11580
4 10000 0.572 5720 0.482 4820
3440 (1256)

IRR is above 15% but below 20%

The Estimation of IRR is therefore:

IRR= IRR = L + NL/NL – NH * (H - L) where:

L = Lower rate of interest

H = Higher rate of interest

NL = NPV at lower rate of interest

NH = NPV at higher rate of interest.

IRR= 15% + 3440 / (3440 – (-1256) * (20 – 15)%

= 15% + 3.7% = 18.7%

The project is expected to earn a DCF return in excess of the target rate of 17%, so on
financial grounds (ignoring risk) it is a worthwhile investment.
 ISLAMIC FINANCE

Islamic finance has the same purpose as other forms of business finance except that it operates
in accordance with the principles of Islamic law (Sharia).

The basic principles covered by Islamic finance include:

 Sharing of profits and losses.

 No interest (riba) allowed.
 Finance is restricted to Islamically accepted transactions. i.e. No investment in alcohol,
gambling etc.

Therefore, ethical and moral investing is encouraged.

Instead of interest being charged, returns are earned by channelling funds into an underlying
investment activity, which will earn profit. The investor is rewarded by a share in that profit,
after a management fee is deducted by the bank. The main sources of finance within the Islamic
banking model include:

 Murabaha (trade credit)

 Ijara (lease finance)
 Sukuk (debt finance)
 Mudaraba (equity finance)
 Musharaka (venture capital).

Islamic sources of finance

In Islamic Banking there are broadly 2 categories of financing techniques:

 ‘Fixed Income’ modes of finance – murabaha, ijara, sukuk

 Equity modes of finance – mudaraba, musharaka.

Each of these is discussed in more detail below:

Murabaha

Murabaha is a form of trade credit or loan. The key distinction between a murabaha and a loan
is that with a murabaha, the bank will take actual constructive or physical ownership of the
asset. The asset is then sold onto the 'borrower' or 'buyer' for a profit but they are allowed to
pay the bank over a set number of instalments. The period of the repayments could be extended
but no penalties or additional mark-up may be added by the bank. Early payment discounts are
not welcomed (and will not form part of the contract) although the financier may choose (not
contract) to give discounts.

Ijara

Ijara is the equivalent of lease finance; it is defined as when the use of the underlying asset or
service is transferred for consideration. Under this concept, the Bank makes available to the
customer the use of assets or equipment such as plant, office automation, or motor vehicles for
a fixed period and price. Some of the specifications of an Ijara contact include:

 The use of the leased asset must be specified in the contract.

 The lessor (the bank) is responsible for the major maintenance of the underlying assets
(ownership costs).
 The lessee is held for maintaining the asset in good shape.

Sukuk

Within other forms of business finance, a company can issue tradable financial instruments to
borrow money. Key feature of these debt instruments are they:

 Don’t give voting rights in the company

 Give right to profits before distribution of profits to shareholders
 May include securities and guarantees over assets
 Include interest based elements.

All of the above are prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are linked
to an underlying asset, such that a sukukholder is a partial owner in the underlying assets and
profit is linked to the performance of the underlying asset. So for example, a sukukholder will
participate in the ownership of the company issuing the sukuk and has a right to profits (but
will equally bear their share of any losses).

Mudaraba

Mudaraba is a special kind of partnership where one partner gives money to another for
investing it in a commercial enterprise. The investment comes from the first partner (who is
called 'rab ul mal'), while the management and work is an exclusive responsibility of the other
(who is called 'mudarib').
The Mudaraba (profit sharing) is a contract, with one party providing 100% of the capital and
the other party providing its specialist knowledge to invest the capital and manage the
investment project. Profits generated are shared between the parties according to a pre-agreed
ratio. In a Mudaraba, only the lender of the money has to take losses.

This arrangement is therefore most closely aligned with equity finance.

Musharaka

Musharaka is a relationship between two or more parties, who contribute capital to a business,
and divide the net profit and loss pro rata. It is most closely aligned with the concept of venture
capital. All providers of capital are entitled to participate in management, but are not required
to do so.

The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each
partner strictly in proportion to their respective capital contributions.
 CROWD FUNDING

Crowdfunding is a way of raising money to finance projects and businesses. It enables

fundraisers to collect money from a large number of people via online platforms.

Crowdfunding is most often used by startup companies or growing businesses as a way of

accessing alternative funds. It is an innovative way of sourcing funding for new projects,
businesses or ideas.

It can also be a way of cultivating a community around your offering. By using the power of
the online community, you can also gain useful market insights and access to new customers.

This guide is aimed at entrepreneurs, businesspeople and companies, especially small and
medium enterprises. If you are thinking about ways of financing a new business or idea, or
have heard about crowdfunding and want to learn more, you may find this guide useful.

How does crowdfunding work?

Crowdfunding platforms are websites that enable interaction between fundraisers and the
crowd. Financial pledges can be made and collected through the crowdfunding platform.

Fundraisers are usually charged a fee by crowdfunding platforms if the fundraising campaign
has been successful. In return, crowdfunding platforms are expected to provide a secure and
easy to use service.

Many platforms operate an all-or-nothing funding model. This means that if you reach your
target you get the money and if you don’t, everybody gets their money back – no hard feelings
and no financial loss.
There are a number of crowdfunding types which are explained below. This guide provides
unbiased advice to help you understand the three most common types of crowdfunding used
by profit-making SMEs and startups: peer-to-peer, equity and rewards crowdfunding.

Main types of crowdfunding

Peer-to-peer lending

The crowd lends money to a company with the understanding that the money will be repaid
with interest. It is very similar to traditional borrowing from a bank, except that you borrow
from lots of investors.

Equity crowdfunding

Sale of a stake in a business to a number of investors in return for investment. The idea is
similar to how common stock is bought or sold on a stock exchange, or to a venture capital.

Rewards-based crowdfunding

Individuals donate to a project or business with expectations of receiving in return a non-

financial reward, such as goods or services, at a later stage in exchange of their contribution.

Donation-based crowdfunding

Individuals donate small amounts to meet the larger funding aim of a specific charitable project
while receiving no financial or material return.

Profit-sharing / revenue-sharing

Businesses can share future profits or revenues with the crowd in return for funding now.

Debt-securities crowdfunding

Individuals invest in a debt security issued by the company, such as a bond.

Hybrid models

Offer businesses the opportunity to combine elements of more than one crowdfunding type.
 OPTIONS

Options are a type of derivative, and hence their value depends on the value of an underlying
instrument. The underlying instrument can be a stock, but it can also be an index, a currency,
a commodity or any other security.

Now that we have understood what options are, we will look at what an options contract is. An
option contract is a financial contract which gives an investor a right to either buy or sell an
asset at a predetermined price by a specific date. However, it also entails a right to buy, but not
an obligation.

When understanding option contract meaning, one needs to understand that there are two
parties involved, a buyer (also called the holder), and a seller who is referred to as the writer.

In India, the National Stock Exchange (NSE) introduced trading in index options on June 4,
2001.

Features of an option contract

Premium or down payment:

The holder of this type of contract must pay a certain amount called the ‘premium’ for having
the right to exercise an options trade. In case the holder does not exercise it, s/he loses the
premium amount. Usually, the premium is deducted from the total payoff, and the investor
receives the balance.

Strike price:

This refers to the rate at which the owner of the option can buy or sell the underlying security
if s/he decides to exercise the contract. The strike price is fixed and does not change during the
entire period of the validity of the contract.

Contract size:

The contract size is the deliverable quantity of an underlying asset in an options contract. These
quantities are fixed for an asset. If the contract is for 100 shares, then when a holder exercises
one option contract, there will be a buying or selling of 100 shares.

Expiration date:

Every contract comes with a defined expiry date. This remains unchanged until the validity of
the contract. If the option is not exercised within this date, it expires.
Intrinsic value:

An intrinsic value is the strike price minus the current price of the underlying security. Money
call options have an intrinsic value.

Settlement of an option:

There is no buying, selling or exchange of securities when an options contract is written. The
contract is settled when the holder exercises his/her right to trade. In case the holder does not
exercise his/her right till maturity, the contract will lapse on its own, and no settlement will be
required.

No obligation to buy or sell:

In case of option contracts, the investor has the option to buy or sell the underlying asset by the
expiration date. But he is under no obligation to purchase or sell. If an option holder does not
buy or sell, the option lapses.

Types of options

Now that it is clear what options are, we will take a look at two different kind of option
contracts- the call option and the put option.

Call option

A call option is a type of options contract which gives the call owner the right, but not the
obligation to buy a security or any financial instrument at a specified price (or the strike price
of the option) within a specified time frame.

To buy a call option one needs to pay the price in the form of an option premium. As
mentioned, it is upon the discretion of the owner on whether he wants to exercise this option.
He can let the option expire if he deems it unprofitable. The seller, on the other hand, is obliged
to sell the securities that the buyer desires. In a call option, the losses are limited to the options
premium, while the profits can be unlimited.

Let us understand a call option with the help of an example. Let us say an investor buys a call
option for a stock of XYZ company on a specific date at Rs.100 strike price and expiry date is
a month later. If the price of the stock rises anywhere above Rs.100, say to Rs.120 on the
expiration day, the call option holder can still buy the stock at Rs.100.
If the price of a security is going to rise, a call option allows the holder to buy the stock at a
lower price and sell it at a higher price to make profits.

Call options are further of 3 types

In the money call option: In this case, the strike price is less than the current market price of
the security.

At the money call option: When the strike price is lower than the current price by an amount
equal to the premium paid for the call option then it is said to be at the money.

Out of the money call option: When the strike price is more than the current market price of
the security, a call option is considered as an out of the money call option.

Put options

Put options give the option holder the right to sell an underlying security at a specific strike
price within the expiration date. This lets investors lock a minimum price for selling a certain
security. Here too the option holder is under no obligation to exercise the right. In case the
market price is higher than the strike price, he can sell the security at the market price and not
exercise the option.

Let us take an example to understand what a put option is. Suppose an investor buys a put
option of XYZ company on a certain date with the term that he can sell the security any time
before the expiration date for Rs.100. If the price of the share falls to below Rs 100, say to Rs
80, he can still sell the stock at Rs.100. In case the share price rises to Rs 120, the holder of the
put option is under no obligation to exercise it.

If the price of a security is falling, a put option allows a seller to sell the underlying securities
at the strike price and minimise his risks.

Like call options, put options can further be divided into ‘in the money’ put options, ‘at the
money’ put options and ‘out of the money’ put options.

In the money put options: A put option is considered in the money when the strike price is
more than the current price of the security.

At the money put option: When the strike price is higher than the current price by an amount
equal to the premium paid for the put option then it is said to be at the money
Out of the money put options: A put option is out of the money if the strike price is less than
the current market price.

Options can also be classified on the exercising style into American and European options.

American options:

These are options that can be exercised at any time up to the expiration date. Select security
options available at NSE are American style options.

European options:

These options can be exercised only on the expiration date. All index options traded at NSE
are European options.

How options work

Now that we have understood what are options, and what is an option contract, let us now
understand how options work:

If you have any security, let us say a stock, you want to sell it at a future date at a higher price.
To make a profit, you have to buy it at a lower price and sell it at a higher price. However,
since the markets are unpredictable, it is not possible to be sure what the prevalent market price
will be. To protect yourself from any potential losses, you can buy a put option. This lets you
sell the stock at a predetermined rate, either before or on the expiration date. Because an options
contract does not come with any obligations, it is a kind of insurance.

If the price of the stock is indeed lower than the strike price, you can exercise the option and
sell your shares at the agreed price that is mentioned on the options contract. By doing so, you
make a profit.

In another situation, the market price for stocks can be higher than expected, leading up to the
expiration date. In that case, the options contract becomes useless as you can directly sell the
shares in the market at a higher price. So an options contract provides a sort of protection
against market situations one has no control over.

Here we have to understand that options are all about determining how prices of a security will
move in the future. If the chances of something happening, say the price of security rising, is
more likely, an option which would profit from such an event would be more expensive.
Another essential factor to consider is time. The value of an option will decrease as the time to
expiry decreases because the chances of the price of the underlying security moving in that
period go down as the date moves towards expiry. So, a six-month option will be less valuable
than a one year option and so on.

By the same logic, volatility also increases the value of options. This is because the more
volatile the market for the underlying security, the odds of a profitable outcome from an options
contract is even higher. More volatility will mean that the price of the underlying security has
more chances of moving up and down and hence higher the volatility, higher the price of an
option.

What are options in trading:

Now we will see the use of options in trading. Let us say that the stock for YXZ company is at
Rs 250. If an investor is bullish on the stock, he may buy a call option with a strike price of Rs
260. For that, he will have to pay a premium. But let us say that the price of the stock for XYZ
company moves up to Rs 280 within the period specified, the investor can buy the stock for Rs
250 and sell it at Rs 280 to make a profit.

On the other hand, if an trader is bearish about a stock, he can buy a put option. Let us say that
the share of XYZ company is trading at Rs 250. If an investor buys a put option for a strike
price of Rs 240, if the stock price falls and is at Rs 220 on the expiration date, the trader can
still sell the shares for Rs 240 and hedge his loss.

Understanding how options are priced

Someone who wants to trade in options should also have an idea of how options are priced.
There are a lot of variables that determine the value of an option. These include the current
stock price, the intrinsic value, the time to expiration, which is also known as the time value
and also other factors like volatility, interest rates, and so on. Several option pricing models
use the above values to arrive at the price of an option. Out of these, the most popularly used
is the Black-Scholes model.

However, certain things hold when it comes to option pricing. The longer the period between
the day the option is purchased and the expiry date, the more valuable the option. That is
because there is more time for the current market price to reach the strike price. The price of
an option can decrease even as the price of a stock goes up if the expiry date is nearing. As the
chances of the price rising to meet the strike price decrease, the price of the option will also
start decreasing as the one approaches the expiration date.

Advantages of options

Low cost of entry:

It allows the investor or trader to take a position with a small amount as compared to stock
transactions. If you are buying actual stocks, you have to shell out a large sum of money which
would be equal to the price of each stock multiplied into the number of stocks you buy.

Hedging against risks:

Buying options is actually like buying insurance for your stock portfolio and minimising your
exposure to risk. In many cases, the premium you end up paying is the maximum limit of your
risk.

Flexibility:

Options give the investor the flexibility to trade for any potential movement in an underlying
security. As long as the investor has a view regarding how the price of a security will move
shortly, he can use an options strategy.

Disadvantages of options

Lower liquidity:

Not many people trade in the options market hence they are not easily available when needed.
This could often mean buying at a higher rate and selling at a lower rate as compared to other
more liquid investment options.

Risk:

Depending on the type of option, an options trader can stand to lose either just the premium or
perhaps even an unlimited sum.

Complicated:

One needs to take a call on the price movement of a particular security and the time by which
this price movement will occur. Getting both right can be tough.

As we have seen above, options have both benefits and disadvantages, both of which should
be considered before someone decides to trade in options.
 FUTURES

Futures are derivative financial contracts that obligate parties to buy or sell an asset at a
predetermined future date and price. The buyer must purchase or the seller must sell the
underlying asset at the set price, regardless of the current market price at the expiration date.

Underlying assets include physical commodities and financial instruments. Futures contracts
detail the quantity of the underlying asset and are standardized to facilitate trading on a futures
exchange. Futures can be used for hedging or trade speculation.

Understanding Futures

Futures—also called futures contracts—allow traders to lock in the price of the underlying
asset or commodity. These contracts have expiration dates and set prices that are known
upfront. Futures are identified by their expiration month. For example, a December gold futures
contract expires in December.

Traders and investors use the term futures in reference to the overall asset class. However, there
are many types of futures contracts available for trading including:1

 Commodity futures with underlying commodities such as crude oil, natural gas, corn,
and wheat

 Stock index futures with underlying assets such as the S&P 500 Index

 Currency futures including those for the euro and the British pound

 Precious metal futures for gold and silver

 U.S. Treasury futures for bonds and other financial securities

It's important to note the distinction between options and futures. American-style
options contracts give the holder the right (but not the obligation) to buy or sell the underlying
asset any time before the expiration date of the contract. With European options, you can only
exercise at expiration but do not have to exercise that right.

The buyer of a futures contract, on the other hand, is obligated to take possession of the
underlying commodity (or the financial equivalent) at the time of expiration and not any time
before. The buyer of a futures contract can sell their position at any time before expiration and
be free of their obligation. In this way, buyers of both options and futures contracts benefit
from a leverage holder's position closing before the expiration date.
Pros of Futures

 Investors can use futures contracts to speculate on the direction of the price of an
underlying asset.

 Companies can hedge the price of their raw materials or products they sell to protect
against adverse price movements.

 Futures contracts may only require a deposit of a fraction of the contract amount with
a broker.

Cons of Futures:

 Investors risk losing more than the initial margin amount since futures use leverage.

 Investing in a futures contract might cause a company that hedged to miss out on
favourable price movements.

 Margin can be a double-edged sword, meaning gains are amplified but so too are
losses.