Forwards vs Options
Lindsey Matthews
30 years: Risk management & derivatives trading
Now that Lindsey has given an overview of forwards and futures, he will explain how they are traded by discussing the differences between an OTC contract and an ETD, the difference between a cash and physical settlement and cover how to price a forward trade.
Now that Lindsey has given an overview of forwards and futures, he will explain how they are traded by discussing the differences between an OTC contract and an ETD, the difference between a cash and physical settlement and cover how to price a forward trade.
Forwards vs Options
9 mins 5 secs
An OTC contract allows both parties involved to agree to the terms exactly as they please, whereas ETDs are standardised, with set amounts, expiry dates and trading mechanisms. The settlements that occur over these contracts can be via cash or physical, both having their benefits and drawbacks. An option is essentially a one-sided version of the forward contract.
Key learning objectives:
Define OTC and ETDs
Outline the pros and cons of physical vs cash settlements
Define an option and understand when it is exercised
What is an over-the-counter (OTC) contract?
An agreement between two parties and, as long as they both agree, the terms can be exactly as they want. It is negotiated and agreed bilaterally between the two parties.
What are exchange-traded derivatives (ETDs)?
The exchange traded version of the forward if a futures contract. Being traded on an exchange means that the contract is standardised - with set amounts, expiry dates, trading mechanisms, and other features that standardise the contracts and therefore make them more liquid.
When may a cash-settled contract be useful?
For example, if the buyer was planning on purchasing platinum from their regular supplier, but did not want to damage their relationship by buying it elsewhere - rather to receive financial compensation for a rise in price. The cash-settled contract simply requires the seller to pay out to the buyer, if the price has gone up; or the buyer to pay out to the seller if the price has gone down.
What is the drawback of a cash settlement?
The need to observe and calculate a cash-settlement price.
What is the exchange determined settlement price (EDSP)?
The level which is used to settle the futures contract. This is often done by observing the index level over a given period of time and taking the average, and removed outliers.
What are the complications of a physical settlement?
- For example, on the platinum futures, there would need to be a process to ensure that the platinum if 0.9995 fine
- For gold futures, the seller s allowed to slightly alter the amount of gold they deliver
- Bond futures are not on single bonds but on a basket of possible deliverable bonds
- Forward trades on US mortgage backed securities allow the seller to choose which exact securities to deliver, at settlement
What is an option?
This is a one-sided version of the forward - a position where the buyer of the forward gets to decide at the end whether they really wanted to do it. For example:
- If the market is up, they use the forward trade and pay the lower price on the forward trade
- If the market is down, they walk away from the forward and just buy the platinum in the market at a lower price than the forward
When would the option be exercised?
- If the platinum price <$1000 an ounce, and so the jeweller walks away from the trade, they lose $50 per share. This is referred to as the option expiring worthless - or expiring “out of the money”
- If the platinum price >$1000, the jeweller will exercise the option, and they will therefore make back some of the premium that was paid. This is referred to as the option expiring “in the money”
- If the price >$1050, then they make back the premium plus more. $1050 is known as the breakeven on the option
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