Sunil K Parameswaran
Futures and forwards have a zero value at inception, for neither the long nor the short is required to pay a price to the counterparty. However, once the contract is sealed, it acquires value as the price changes in the forward/futures market.
The value of a long forward position is the present value of the difference between the current forward price and the delivery price of the contract. The value of a short forward position is just the negative of this. Thus as the forward price increases, the value of a long forward position increases, whereas as the forward price declines the value of such a position will decline.
Since forwards are a zero sum game, the implications of rising/declining prices will be just the opposite for short forward positions. A positive value means that someone has to pay you money to take over your position. A negative
value would imply that you need to pay to tempt someone to take over your existing position.
Marked to market
Futures contracts, however, differ because they are marked to market. Rising futures prices are positive for longs while falling prices are good for shorts. The difference arises because each day when the position is marked to market, the built up value is settled, and the value of the position is reset to zero. Thus the only period where a futures contract acquires value is in the interval between two successive marking to market computations.
Options have a non-negative value at all times. In an options contract, the long is conferred with a right while simultaneously a contingent obligation is imposed on the short. Obviously the long needs to pay an upfront option price or premium. The price of an option has two components, an intrinsic value and a time value.
The intrinsic value is the extent to which the option is in the money, else it is equal to zero. Thus in the money calls, puts will have a positive intrinsic value. By definition the intrinsic value of an option cannot be negative. The intrinsic value is what the holder would get if the option is immediately exercised, if the option is in the money. At the money and out of the money, options will not be exercised and consequently have an intrinsic value of zero.
The second component of the option premium is the time value or speculative value. This is the price paid by the long for what could happen subsequently. All American options have a non-negative time value, whether or not the underlying asset is scheduled to make a payout during the time of the contract. Thus these options are priced at a minimum of their intrinsic values.
The writer is an author, and a visiting faculty at various institutes including the IIMs