FORWARD CONTRACT: relatively simple derivative is a forward contract.

It is an
agreement to buy or sell an asset at a certain future time for a certain price. It can be
contrasted with a spot contract, which is an agreement to buy or sell an asset almost
immediately. A forward contract is traded in the over-the-counter market—usually between
two financial institutions or between a financial institution and one of its clients.
One of the parties to a forward contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price. The other
party assumes a short position and agrees to sell the asset on the same date for the same price.
Forward contracts on foreign exchange are very popular. Most large banks employ
both spot and forward foreign-exchange traders. There is a relationship between forward
prices, spot prices, and interest rates in the two currencies.

Ex-
Imagine you're in charge of a big company in the US, and you know you'll need to
pay a million pounds to someone in the UK six months from now. You're worried that
the exchange rate might change by then, making it more expensive for you.

So, you decide to do something about it. You look at a table that shows the
exchange rates between US dollars and British pounds. It tells you what different
banks are willing to pay or receive for pounds, both right away (spot market) and in
the future (forward contracts).

Let's say you find a bank that agrees to sell you a million pounds six months from
now at a fixed rate of $1.5532 per pound. This means you're locking in this exchange
rate, so even if the rate changes later, you'll still pay the same amount.

So, on November 6th, when you need the pounds, you'll buy them from the bank at
the agreed-upon rate. The bank, on the other hand, has agreed to sell you the
pounds at that rate. This way, both you and the bank are protected from any changes
in the exchange rate that could have cost you more money. It's like a promise that
you both have to keep.
Keywords: future time for a certain price ,over-the-counter market, between a financial
institution and one of its clients, long position, specified future date for a certain
specified price, short position, same date for the same price.

Payoffs from Forward Contracts:

1. If the exchange rate goes up:
• Imagine the value of the British pound rises a lot in those six months.
• Because the company locked in the exchange rate earlier, they'd save
money compared to buying at the new, higher rate.
• In this case, the forward contract would be worth extra money to the
company. They'd gain $46,800 because they'd pay less than if they
bought at the new rate.
2. If the exchange rate goes down:
• On the flip side, let's say the value of the pound drops.
 • The company would end up paying more for the pounds than they
would if they waited and bought them at the new, lower rate.
• In this situation, the forward contract would cost the company. They'd
lose $53,200 because they'd end up paying more than if they waited
and bought pounds at the new rate.
3. Explanation of the Payoff:
• Generally, if you're in a forward contract to buy something, and the
actual price (spot price) is higher than what you agreed to pay (delivery
price), you save money. So your payoff is the spot price minus the
delivery price.
• If you're in a forward contract to sell something, and the actual price
(spot price) is lower than what you agreed to sell for (delivery price),
you make money. So your payoff is the delivery price minus the spot
price.
• These payoffs can be good or bad, depending on how the exchange
rate changes.
• And because you don't have to pay anything upfront for a forward
contract, whatever you gain or lose from the contract is your total gain
or loss.
In general, the payoff from a long position in a forward contract on one unit of an asset is
ST - K
where K is the delivery price and ST is the spot price of the asset at maturity of the
contract.
This is because the holder of the contract is obligated to buy an asset worth S T for K.
Similarly, the payoff from a short position in a forward contract on one unit of an asset is
K – ST
These payoffs can be positive or negative. They are illustrated in following figure.
Because it costs nothing to enter into a forward contract, the payoff from the contract is also
the trader’s total gain or loss from the contract.
Forward Prices and Spot Prices:

Imagine you have a stock that costs $60, and you can either borrow or lend money at
a 5% interest rate for a year. Here's what happens with forward prices:

1. Forward Price at $63:

• If the forward price is $63, it means you can sell the stock in the future
for $63.
• But if you can buy it now for $60, you'd do that, right?
• So, you'd borrow $60, buy the stock, and then sell it forward for $63.
• After a year, you'd pay back the loan with interest, which would be $63
x 5% = $3.
• You bought the stock for $60, sold it for $63, and paid back $63 x 5% =
$3.
• So, you'd make a net profit of $4 in one year.
2. Forward Price at $58:
• Now, let's say the forward price is $58, lower than the expected $63.
• If you already have the stock, you'd sell it for $60 and then enter into a
forward contract to buy it back for $58 in a year.
• So, you'd get $60 for selling the stock.
• Then, you'd invest that money at 5%, earning $3 in a year.
• So, in total, you'd end up $5 better off than if you kept the stock in
your portfolio for the year.

So, in summary:

• If the forward price is higher than expected, you can make a profit by buying
the stock now and selling it forward.
• If the forward price is lower than expected, you can make a profit by selling
the stock now and buying it back later at the lower forward price.

FUTURE CONTRACTS:

Like a forward contract, a futures contract is an agreement between two parties to

buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts,
futures contracts are normally traded on an exchange. To make trading possible, the exchange
specifies certain standardized features of the contract. As the two parties to the contract do
not necessarily know each other, the exchange also provides a mechanism that gives the two
parties a guarantee that the contract will be honored.
The largest exchanges on which futures contracts are traded are the Chicago Board of
Trade (CBOT) and the Chicago Mercantile Exchange (CME), which have now merged to
form the CME Group.
On these and other exchanges throughout the world, a very wide range of
commodities and financial assets form the underlying assets in the various contracts. The
commodities include pork bellies, live cattle, sugar, wool, lumber, copper, aluminum, gold,
and tin.
 The financial assets include stock indices, currencies, and Treasury bonds. Futures
prices are regularly reported in the financial press.
Suppose that, on September 1, the December futures price of gold is quoted as $1,380.
This is the price, exclusive of commissions, at which traders can agree to buy or sell gold for
December delivery. It is determined in the same way as other prices (i.e., by the laws of
supply and demand). If more traders want to go long than to go short, the price goes up; if the
reverse is true, then the price goes down.

Options are traded both on exchanges and in the over-the-counter market.

There are two types of option.
1. A call option gives the holder the right to buy the underlying asset by a certain date
for a certain price.
2. A put option gives the holder the right to sell the underlying asset by a certain date for
a certain price.
The price in the contract is known as the exercise price or strike price; the date in the
contract is known as the expiration date or maturity.
American options can be exercised at any time up to the expiration date. European
options can be exercised only on the expiration date itself. (Note: Note that the terms
American and European do not refer to the location of the option or the exchange. Some
options trading on North American exchanges are European.) Most of the options that are
traded on exchanges are American.
In the exchange-traded equity option market, one contract is usually an agreement to
buy or sell 100 shares. European options are generally easier to analyze than American
options, and some of the properties of an American option are frequently deduced from those
of its European counterpart.
It should be emphasized that an option gives the holder the right to do something. The
holder does not have to exercise this right. This is what distinguishes options from forwards
and futures, where the holder is obligated to buy or sell the underlying asset. Whereas it costs
nothing to enter into a forward or futures contract, there is a cost to acquiring an option.
The largest exchange in the world for trading stock options is the Chicago Board
Options Exchange (CBOE; www.cboe.com).

Explaination with example: Following table (1.2) gives the bid and offer quotes for some of
the call options trading on Google (ticker symbol: GOOG) on May 8, 2013. Following table
(1.3) does the same for put options trading on Google on that date. The quotes are taken from
the CBOE website. The Google stock price at the time of the quotes was bid 871.23, offer
871.37. The bid–offer spread on an option (as a percent of the price) is usually greater than
that on the underlying stock and depends on the volume of trading. The option strike prices in
Tables 1.2 and 1.3 are $820, $840, $860, $880, $900, and $920. The maturities are June 2013,
September 2013, and December 2013. The June options expire on June 22, 2013, the
September options on September 21, 2013, and the December options on December 21, 2013.
The above tables illustrate a number of properties of options. The price of a call option decreases as
the strike price increases, while the price of a put option increases as the strike price increases.
Both types of option tend to become more valuable as their time to maturity increases.

1. What's Happening:
• There are two tables showing the prices for options on Google stock.
• One table is for call options (which let you buy the stock), and the other
is for put options (which let you sell the stock).
2. Understanding the Tables:
• Each table has different strike prices and expiration dates listed.
• Strike prices are the prices at which you can buy or sell the stock if you
choose to exercise the option.
• Expiration dates are when the options contracts end.
3. Observations:
• The price of call options tends to decrease as the strike price (the
buying price) increases.
• On the other hand, the price of put options tends to increase as the
strike price increases.
• Both types of options become more valuable as the time until their
expiration date increases.
4. Why It Matters:
• These observations help investors understand how options work and
how their prices change based on different factors.
• It's essential for investors to analyze these prices and understand how
they relate to the current stock price and future expectations.

In simple terms, the tables show how the prices of options change depending on
what you can do with them (like buy or sell the stock) and when they expire. It's like
seeing how much different types of insurance cost and how they change based on
what they cover and when they expire.

Call option explaination with example:

Imagine an investor wants to make a deal to potentially buy Google stock in
December at a certain price. They tell a broker to buy one option contract, which
gives them the right to buy 100 shares of Google stock for $880 each.

1. Making the Deal:

• The broker talks to someone at the Chicago Board Options Exchange
(CBOE) to make the deal happen.
• The price for this option contract is $56.30 per share, but remember,
one option contract covers 100 shares.
2. Paying for the Option:
• Since the contract is for 100 shares, the investor needs to pay 100 times
the price per share, which is $56.30.
• So, the total cost for the option contract is $5,630.
3. What Happens Next:
• If by December 21, 2013, the price of Google stock doesn't go above
$880, the investor loses the $5,630 they paid for the option.
• But if Google does well and the stock price goes up, let's say to $1,000,
the investor can use their option to buy 100 shares at $880 each, even
though the market price is higher.
• Then, they can sell those shares immediately at the market price of
$1,000 each.
• They'd make a profit of $120 per share ($1,000 - $880), and since they
have 100 shares, their total profit would be $12,000.
• When we subtract the initial cost of the option ($5,630) from the profit,
the investor ends up with $6,370.

So, in simple terms, by paying $5,630 for the option, the investor gets the chance to
make a profit if the price of Google stock goes up. If it doesn't go up enough, they
lose the money they paid for the option.
Put option explaination with example:

Imagine another way to make a trade with Google stock options. Instead of buying
an option, this time, the investor sells an option contract.

1. The Trade:
• The investor decides to sell one option contract for September with a
"put" option. This means they're giving someone else the right to sell
them Google stock at a certain price ($840 in this case).
2. Immediate Cash Inflow:
• By selling this option, the investor gets paid right away. The price for
this option contract is $31 per share, and since one contract covers 100
shares, the total cash inflow is $3,100.
3. Possible Outcomes:
 If the price of Google stock stays above $840, the person who bought
•
the option won't want to sell the stock to the investor for less than it's
worth on the market. So, the option won't be exercised, and the
investor keeps the $3,100 they got for selling the option.
• But if the stock price falls below $840 and the option is exercised, let's
say when the stock price is $800, the investor has to buy 100 shares at
$840 each, even though they're worth only $800 each on the market.
This results in a loss of $4,000.
• However, when we consider the initial $3,100 the investor received for
selling the option, the total loss is reduced to $900.
4. Understanding the Market Participants:
• There are four types of participants in options markets:
1. Buyers of calls (those who think the stock price will go up)
2. Sellers of calls (those who think the stock price will stay the same
or go down)
3. Buyers of puts (those who think the stock price will go down)
4. Sellers of puts (those who think the stock price will stay the
same or go up)
• Buyers are called "long" positions, and sellers are called "short"
positions. Selling an option is also known as "writing" the option.

So, in simple terms, by selling the put option, the investor gets paid upfront. If the
stock price stays high, they keep the money they received. But if the stock price
drops too much, they might end up having to buy the stock at a higher price than it's
worth, resulting in a loss.

TYPES OF TRADERS:
Derivatives markets have been outstandingly successful. The main reason is that they
have attracted many different types of traders and have a great deal of liquidity. When an
investor wants to take one side of a contract, there is usually no problem in finding someone
who is prepared to take the other side.
Three broad categories of traders can be identified:
1) Hedgers,
2) Speculators, and
3) Arbitrageurs.

Hedgers use derivatives to reduce the risk that they face from potential future movements in a
market variable.
Speculators use them to bet on the future direction of a market variable.
Arbitrageurs take offsetting positions in two or more instruments to lock in a profit.