Futures and options: working

Résumé du document

Since the 1970's, the trade of derivative securities has over expanded and has characterised most of the transactions in the world financial marketplaces. However, derivatives do not constitute a new notion in the financial world, since they first appeared in the 17th century, with the trade of commodities. Hence, cultivators, to hedge risks -that means to protect themselves from variations between the sale price and the delivery price- looked for a solution, a contract that would guarantee them a minimum price, so that they can still make profit. Derivatives securities are instruments whose values are derived from the values of other relates securities. There are various types of derivatives but the two most popular ones are financial options and futures. The former can be defined as a "contract that gives its holder the right to purchase (call option) or sell (put option) a specified asset under specified conditions".

Extraits

[...] The mutual funds will gain on its futures position, because the price it paid for the index at the settlement date will be less than the future price at which it sold the index. Yet this system only works if there is no error with the correlation between the portfolio and the index[8]. We can envisage many other different scenarios of hedging risks with futures. Consider a variation in the price of raw material. Let's imagine a company which produces cotton bed sheet. [...]

[...] There are three kinds of call options. First, a call option is said to be the money” when the prevailing stock price is above the exercise price, and is at the level where the option may be exercised. Second, the call option is the money” when the prevailing stock price is equal to the option's exercise price. Third, a call option is of money” when the prevailing stock price is below the option's exercise price[11]. On the other side, a put option is the money” when the prevailing stock price is below the exercise price, the money” when the prevailing stock price is equal to the put option's exercise price, and the money” when the prevailing stock price is above the option's exercise price. [...]

[...] On the other hand, if the price of the asset falls, it is the put which is profitable. Otherwise, one can only trade a “strangle'. The latter consists of a put and a call with the same expiration date and the same underlying good. The difference is that the two contracts have not the same exercise prices. The buyer of a strangle expects that the volatility is going to be high whereas the seller of ha strangle expects a low volatility. [...]

[...] Also, there can either be OTC options or traded options. The main difference between those two types is that the latter can be traded to parties other than the original seller. Besides, there is a distinction between American style and European style option. The first one enables investors to exercise their right at any time prior to the expiration date, whereas the second one can only be exercised on the expiration date. It is profitable to exercise call options when the market price of the stock is higher than the strike price. [...]

[...] To conclude, one can say that derivatives such as futures and options are very efficient and useful instruments in the financial markets. Indeed, by the system of hedging, one can reduce risk and maintain a certain stability vis-à-vis the variations of prices, exchanges rates or interest rates Yet the complexity of derivative trading is huge and a good understanding of the different mechanisms is required to maximise profit and to avoid market crisis. However, in recent years, individual company losses through derivatives have become almost “routine”.[14] One justification for the phenomenon is about speculation which can lead to very unstable situations. [...]