is baWhy Options Are Better Than Futures For Hedging
Futures trading can be used for two main purposes; Speculation and Hedging. While most retail futures traders get involved in futures trading for the purpose of leveraged speculation, it cannot be forgotten that the true purpose of futures contracts is for the purpose of hedging.

Hedging using futures is technique most professional money managers use for decades. However, there is one main problem with hedging using futures and that is the fact that the settlement price of futures contracts isnt the actual spot price of their underlying asset. Thats right. In other words, the price of the underlying asset used to determine the worth of each futures contracts isnt the actual price of the underlying asset but a price derived from the actual price known as the Settlement Price. The problem with settlement price is that it can vary significantly from the actual price of the underlying asset and this difference in pricing may cause problems with hedging precisely using futures contracts.

Settlement price is determined at the end of each trading day or trading period by various methods, including price averaging across a certain period, and reflects the future price expectation of the underlying asset at various expiration months. This is why futures contracts of different months have a different price even though they are all based on the same underlying asset. In fact, some futures contracts may end up lower on days where the spot price of the underlying asset actually went up!

As a result of this tracking error between the settlement price and the actual spot price, it is nearly impossible to hedge a position to delta neutrality completely using futures.

This is also why options are becoming the new favorite hedging instrument of professional portfolio managers and are used much more commonly in stock hedging than their single stock futures counterpart.

...of the derivative changes in response to changes in the price of the underlying asset. Currently there are derivatives on all asset classes such as currencies, commodities, stocks, stock indices, precious metals, etc.
Derivatives can be traded both organized stock exchanges or organized or not also called counter markets.
Like any contract, the derivatives are settled at a future date.
Role of Financial Derivatives.
We can classify financial derivatives based on different parameters. The most common are:
1. Derivatives according to the type of contract involved:
a. Options.
b. Forwards.
c. Contracts for difference.
d. SWAPS.
2. Depending on where derivatives are traded and traded:
Derivatives traded on organized markets: Here are standardized contracts on underlying assets that were previously authorized. Furthermore, both the exercise price and the maturity of the contracts are the same for all participants. The operations are performed on an exchange or regulated and organized center such as the Chicago Mercantile Exchange in the United States, where he traded derivatives and futures contracts.
Derivatives contracted in unorganized or OTC markets: These are derivatives whose contracts and specifications are tailored to suit the parties to the derivative contract. In these markets there is no standardization and parties often set the conditions that favor them more.
3. Derivatives as the underlying...

...Options & Futures
I. Introduction to Derivatives
Prof. Domenico Cuoco
Term 5, 2013
What is a Derivative?
Basic Types of Derivatives
The Market for Derivatives
Outline
1
What is a Derivative?
2
Basic Types of Derivatives
3
The Market for Derivatives
Options & Futures, Prof. Domenico Cuoco, 2013
I. Introduction to Derivatives
2
What is a Derivative?
Basic Types of Derivatives
The Market for Derivatives
What is a Derivative?
Derivatives and Contingent Claims
Contingent claims are ﬁnancial contracts that entitle the counterparties
to payoffs that are contingent on the realization of some underlying
random variables.
Examples: lottery tickets, insurance policies, catastrophe bonds.
Derivatives are a special class of contingent claims in which the
underlying variable that determines the payoffs to the counterparties is
the market price of another traded asset (called the underlying asset).
As a result, the value of a derivative is determined by (i.e., derives from)
the value of the underlying asset.
Options & Futures, Prof. Domenico Cuoco, 2013
I. Introduction to Derivatives
3
What is a Derivative?
Basic Types of Derivatives
The Market for Derivatives
Forwards
Futures
Swaps
Vanilla Options
Basic Types of Derivatives
The two basic types of derivatives are:
Forwards
Vanilla...

...Through Some Examples of Futures and
Options Contracts – Speculation and Hedging
As Dr. Cogley said in class the other day, sometimes futures contracts and options are
hard to wrap your head around until you see them a few times. So I’ve written up some
examples similar to those Dr. Cogley did in lecture, with a little more explanation about
how we get the results that we do. But before we jump into that, we need to revisit our
terms.
1. Forward contract: A buyer and a seller agree to a specific price/quantity exchange
sometime in the future. Forward contracts are done between individuals (no
intermediary), so all financial risk is born by those in the contract, which may
result in some sort of risk premium factor being included.
2. Futures contract: Similar to forward contracts, but sold via exchange markets
which act as intermediaries. By charging small transaction costs, the
intermediaries cover possible default by either party, meaning those in the
transaction no longer have to concern themselves with default risk.
3. Options contract: Similar to futures contracts, but without the binding effect – you
pay a premium now to have the right to buy or sell in the future, but you don’t
have to if you decide you don’t want to.
a. Call vs. put: call is the option to buy a security in the future at a set price,
whereas a put...

...the underlying asset for a certain price at a certain time in future. When the enters into a short forward contract, he/she is agreeing to sell the underlying asset for a certain price at a certain time in future.
2. Explain carefully the difference between hedging, speculation, and arbitrage.
Ans: A trader hedges when he/she has an exposure to the price of an asset and takes a position in a derivative to offset the exposure. In the case of speculation, the trader has no such exposure to offset. The trader is simply betting on the future movements of the asset. Arbitrage involves taking a position in two or more markets to lock in a profit.
3. Can you explain the difference between selling a call option and buying a put option?
Ans: Selling a call option involves giving someone else the right to buy an asset from you. It gives you a payoff of
-max(St-K-0)=min (K-St,0)
On the other hand, buying a put option involves buying an option from someone else. It gives you a payoff of
Max (K-St,0)
It may be noted that in both cases the payoff is K-St. When you write a call option, the payoff is negative or zero since the counterparty chooses to exercise. When you buy a put option, the payoff is zero or positive since you choose whether to exercise or not.
4. What is the difference between entering into a long forward...

...Cain’s dilemma is that should she hedge her company’s position to protect them from exchange rate risk or should she just let things continue the way they are.
We believe that before buying a hedge option, she should forecast the profit or loss she may incur with the hedge. So, since she expects the USD to appreciate, it would be advisable for her to either short a forward contract or call option.
A forward contract is an agreement between a corporation and a financial institution to exchange a specific amount of a currency at a specified exchange rate (known as the forward rate), on a specified date in the future. However, the disadvantage of a forward contract is that both the parties are obligated to fulfill their duties; thus the buyer must buy and the seller must sell. In the case of Pixonix, Cain expects the USD rate to appreciate. Therefore she will undergo a contract with a financial institution, to buy USD rates at a predetermined rate (which is expected to be lower than the forward rate) in the end of January. However, if at the end of January the USD depreciates to a rate below the predetermined forward rate, then Pixonix Inc. will suffer a loss because they will have to buy USD for more expensive.
The second Hedging option is a call option. When you buy a call option, you are basically buying the right to buy a currency at a specified price at on a specified...

...Fundamentals of Futures and Options Markets, 8e (Hull)
Chapter 1
Introduction
1) A one-year forward contract is an agreement where
A) One side has the right to buy an asset for a certain price in one year's time
B) One side has the obligation to buy an asset for a certain price in one year's time
C) One side has the obligation to buy an asset for a certain price at some time during the next
year
D) One side has the obligation to buy an asset for the market price in one year's time
Answer: B
2) Which of the following is NOT true?
A) When a CBOE call option on IBM is exercised, IBM issues more stock
B) An American option can be exercised at any time during its life
C) An call option will always be exercised at maturity if the underlying asset price is greater than
the strike price
D) A put option will always be exercised at maturity if the strike price is greater than the
underlying asset price
Answer: A
3) Which of the following is approximately true when size is measured in terms of the
underlying principal amounts or value of the underlying assets?
A) The exchange-traded market is twice as big as the over-the-counter market
B) The over-the-counter market is twice as big as the exchange-traded market
C) The exchange-traded market is ten times as big as the over-the-counter market
D) The over-the-counter market is ten times as big as the...

...CHAPTER 7: CURRENCY FUTURES AND OPTION MARKETS
7.1 FUTURE CONTRACTS
7.1.1 Definition of future contract–> contracts written requiring a standard quantity of an available currency at a fixed exchange rate and at a set delivery date.
A future contract is defined as a contractual agreement to buy or sell an asset at a pre-determined price in the future. The contracts detail the quality and quantity of the underlying asset.
Background of currency futures in 1972: Chicago Mercantile Exchange (CME) opens International Monetary Market (IMM) CME began with grain and commodities future contracts more than a hundred years ago.
7.1.2 The International Monetary Market (IMM) provides:
a) An outlet for hedging currency risk with future contracts (* explanation of hedging next page)
b) Definition of future contracts (above)
c) Main available futures currencies
* EUR (Euro) - CHF (Swiss Franc)
* GBP (Britain Pound) - BRL (Brazilian Real)
* CAD (Canadian Dollar) - AUD (Australian Dollar)
* JPY (Japanese Yen) - NZD (New Zealand Dollar)
d) Standard contract sizes contract sizes differ for each of the available currencies. For example:
EUR = 125.000
GBP = 62.500
e) Transaction costs : payment of commission to a trader
f) Leverage is high the...

...1. As an option writer, what is the best option to take when you forecast the market to be bullish? Sketch the profit/loss diagram and determine the in the money, out of the money and at the money.
2. The call option of Diamond Bhd stock has a striking price of RM30 and a cost of option RM2 per share with one month expiration date. The current market price of share is RM26. If you buy 3 lots (1 lots = 100 shares) of shares, calculate the profits or losses at the expiration date for each of the following prices:
I. RM30
II. RM40
III. RM25
At RM30, SP = EP, ATM , do not to exercise –pay only premium
SP | 30 x 300 = RM9,000 |
EP | 30 x 300 = RM9,000 |
Gross profit | 0 (ATM) |
Premium | (2x300) = (RM6,00) |
Loss | = (RM600) |
At RM 40, SP >EP , ITM, exercise the option
SP | 40 x 300 = RM12,000 |
EP | 30 x 300 = RM 9,000 |
Gross profit | RM 3,000 (ITM) |
Premium | (2x300) = (RM 600) |
Profit | = RM2,400 |
At RM 25, SP <EP , OTM, do not exercise
SP | 25 x 300 = RM7,500 |
EP | 30 x 300 = RM 9,000 |
Gross profit | RM1,500(ITM) |
Premium | (2x300) = (RM 600) |
loss | = RM 600 only pay the maximum loss (premium) |
3. The cost of put option for Syarikat Gemerlapan is RM150 per lot. You wish to buy 3 lots....