Unravelling contingent & commitment contracts

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SummaryForward and futures contracts are what we have termed as ‘commitment contracts’. That is, once a trader takes a position in such contracts, be it a long or short position, he has a binding commitment to perform, whether or not it is profitable on an ex-post basis.

Forward and futures contracts are what we have termed as ‘commitment contracts’. That is, once a trader takes a position in such contracts, be it a long or short position, he has a binding commitment to perform, whether or not it is profitable on an ex-post basis.

Such contracts can be used for both speculation, which implies the assumption of a calculated risk, and for hedging, which refers to the assumption of a derivatives position to mitigate, if not eliminate, a trader’s prior exposure to price risk.

If such contracts are used for speculation, there is the potential for handsome profits if the trader reads the market movement correctly, but there is always the possibility of a significant loss if he were to misread it. This is true from the standpoint of both bulls as well as bears. Similarly, while hedging represents an attempt to avoid risk, there is no assurance that the outcome with hedging will be superior to what would have transpired had the trader chosen to remain unhedged.

Options contracts work a little differently from forward and futures contracts and are termed as ‘contingent contracts’. This is because the holder or buyer of an option is bestowed with a right to transact, while the seller or the writer of an option is required to assume an obligation. An option holder may acquire the right to buy the underlying asset, or else, he may acquire the right to sell the underlying asset. Consequently, we have two categories of options — call options, which correspond to the right to buy, and put options, which bestow the right to sell.

Since the nature of such contracts requires a party to take an obligation on himself, while conferring the counter-party with a right, such contracts entail the payment of a price by the buyer to the seller at the outset. This is known as an ‘option price’ or ‘option premium’, and is a non-refundable amount. In the case of options, the contracts will specify a price for the underlying asset known as the ‘exercise price’. If the price of the underlying asset were to exceed the exercise price, the holder of a call option would exercise his right to acquire the asset by paying the exercise price to the seller.

Similarly, in the event of the terminal asset price being lower than the exercise price, the holder of a put option

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