When you buy a Metro Card, you enter into an agreement with the Transit Authority. You agree to buy transport services in the future while the MTA agrees to sell you the same. The price for these future purchases is set by MTA today.
A forward contract is analogous to a Metro Card. It is an agreement between two parties to buy and sell an asset in the future for a certain price (the delivery price) set today.
If you agree to be on the buy side (you are the party purchasing the asset) you have a long position. If you agree to be on the sell side (you are the party selling the asset) you have a short position.
A forward contract is generally an agreement between institutions. It is not traded on an exchange. On the maturity or settlement date the gain or loss to a party is the difference between the delivery price and the market price.
Both parties involved are obligated to perform their side of the transaction. A forward contract is also a zero sum game. This means that if I win, you will most definitely lose.
Example – The Investment Bank Intern
Your first year internship in Europe with a bulge bracket investment bank will pay you 10,000 pounds net of taxes and expenses. You are worried that the British Pound is overvalued right now and by the time you take the money home, it would be worth less in dollars.
You buy a forward contract from the FX desk in your bank to exchange 10,000 pounds for 15,000 dollars three months from now. The contract locks in the current exchange rate of 1.5 dollars for a pound.
Three months later if your prediction was correct and the pound falls to a new exchange rate of 1.3 dollars to a pound you win and gain 2,000 dollars [(1.5-1.3) * 10,000)]. If you had not used forwards you could only get 13,000 dollars for your pounds. With the forward you can get 15,000 dollars, hence the gain.
On the other hand if the pound rises to a new exchange rate of 1.9 dollars to a pound you would lose 4,000 dollars [(1.9-1.5)* 10,000]. You can get 19,000 dollars for your pounds but with the forward will only get 15,000, hence the loss.
In both cases you would end up with 15,000 US $ in exchange for 10,000 Sterling.
Let’s go back to our example in the previous section about forward contracts. Suppose instead of buying the contract from the FX desk, you bought it from a friend at work who disagreed with your assessment of the British pound. The two of you agree to exchange 10,000 British pounds for 15,000 US dollars three months later.
When the time comes to settle the account the pound is trading at 1.3 dollars to a pound. You saved two thousand dollars and feel very lucky. Then your friend calls up and tells you that he will not be able to keep his end of the bargain. He has lost everything he had on his bets on the British pound.
What can you do now? Your only option is to exchange pounds at the current rate of 1.3 dollars to a pound. Although your prediction was correct and you took timely action, you were still not able to protect yourself. This is called Counter party or Credit risk; the risk that the party on the other side of the transaction will not be able to keep their end of the deal.
Was there anything you could have done differently? Yes, you could have bought a future contract. A future contract is very similar to a forward contract except that it has very little Credit Risk. First, instead of dealing directly with a third party, you deal with an exchange. The exchange guarantees performance of the contract. If the party on the other side reneges, the exchange will settle with you first and then recover what it can from the third party.
To enter into a future contract an initial margin is posted by both parties at the exchange. This is money held on by the exchange as a performance bond. The exchange further reduces its risk by calculating the net gain and loss on a daily basis from closing market prices. Net gains and losses at the end of each trading day are posted to your margin account. If total losses on your account exceed a set % of the margin you have to bring the margin back to its original balance by making additional deposits. In case of gains you can take out any amounts over the initial margin. If you fail to do so, your account is closed and the remaining margin is used by the exchange to recoup its losses.
A future contract is also different from a forward contract in two other ways. First a future contract is a standardized contract used all over the exchange, while a forward contract is customized. Second a future contract has a settlement month, but no exact settlement date. A forward contract has a fixed maturity date.
The problem with forwards and futures is that although you are protected against the downside, you also lose the upside. Options address this problem. They protect you against adverse outcomes, while allowing you to profit from favorable events.
Like forwards and futures, options give you the right to buy or sell a financial asset for a certain price before a certain date in the future. The price is set today and is known as the exercise price.
Unlike forwards and futures as a buyer there is no obligation to perform. You can exercise the option if you benefit from it; if you don’t you can walk away. But unlike forwards and futures you have to pay a premium to buy an option.
The two simplest (aka vanilla) options type that we will work with in this course are call and put option contracts.
Calls give you the right to buy a financial asset for a set price in the future. You would use a call if you expect the underlying price to go up. You would exercise the call if the underlying price at maturity was greater than the exercise price. For this reason a call is classified as a bullish instrument.
A Put option is the opposite of a call option. A Put option gives you the right to sell a security at a set price at a set date in the future. You would use a Put if you expect the underlying price to go down. You would exercise the put if the underlying price at maturity was less than the exercise price. For this reason puts are classified as bearish instruments.
Maturities and Exercise date
Options generally come with exercise choices. Options that can be exercised at any time prior to maturity are known as American options. Options that can only be exercised at maturity are known as European options. Other configurations are also possible and include Bermudan or Mid-Atlantic (exercisable on multiple pre-set dates before expiry) and Asian (based on an average of prices that replaces the exercise price of the option or the price of the underlying at maturity.)