Fundamentals of Financial Instruments. Sunil K. Parameswaran

Fundamentals of Financial Instruments - Sunil K. Parameswaran


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a customized contract, the preceding terms and conditions have to be negotiated between the buyer and the seller of the contract. Hence, the two parties are at liberty to incorporate any features that they can mutually agree to. Forward contracts come under this category. In standardized contracts, however, there is a third party that will specify the allowable terms and conditions. The two parties to the contract have to design the terms and conditions within the framework specified by the third party and cannot incorporate features other than those that are specifically allowed. The third party in the case of futures contracts is the futures exchange, which is the trading arena where such contracts are bought and sold.

      As mentioned, both forward and futures contracts, despite the differences inherent in their structures, impose an obligation on the buyer and the seller. Thus, the buyer is obliged to take delivery of the underlying asset on the date that is agreed upon at the outset, while the seller is obliged to make delivery of the asset on that date and accept cash in lieu.

      Options contracts are different. Unlike the buyer of a forward or a futures contract, the buyer of an options contract has the right to go ahead with the transaction, subsequent to entering into an agreement with the seller of the option. The difference between a right and an obligation is that a right need be exercised only if it is in the interest of its holders, and if they deem it appropriate. Thus, the buyer or holder of the contract does not face a compulsion to subsequently go through with the transaction. However, the seller of such contracts always has an obligation to perform if the buyer were to deem it appropriate to exercise that right.

      EXAMPLE 1.2

      When a person is given a right to transact in the underlying asset, the right can obviously take on one of two forms. That is, that person may either have the right to buy the underlying asset, or the right to sell the underlying asset. Options contracts that give the holder the right to acquire the underlying asset are known as Call options. If the buyer of such an option were to exercise that right, the seller of the option is obliged to deliver the underlying asset as per the terms of the contract. Peter, in the previous example, obviously possesses a call option.

      There exist options contracts that give the holder the right to sell the underlying asset. These are known as Put options. In the case of such contracts, if the holder were to decide to exercise his option, the seller of the put is obliged to take delivery of the underlying asset.

      Options give the holder the right to buy or sell the underlying asset. If the contract were to permit exercise only at the time of expiration, the option, whether a call or a put, is known as a European option. If such an option were not to be exercised at the time of expiration, then the contract itself would expire. There exists another type of contract, where the holder has the right to transact at any point between the time of acquisition of the right and the expiration date of the contract. These are referred to as American options. Quite obviously, the expiration date is the only point in time at which a European option can be exercised, and the last point in time at which an American option can be exercised.

      Futures and forward contracts, however, do not require either party to make a payment at the outset, because they impose an equivalent obligation on both the buyer and the seller. The futures price, which is the price at which the buyer will acquire the asset on a future date, will be set in such a way that the value of the futures contract at inception is zero, from the standpoint of both the buyer as well as the seller.

      A swap is a contractual agreement between two parties to exchange cash flows calculated on the basis of prespecified terms at predefined points in time.

      The cash flows being exchanged represent interest payments on a specified principal amount, which are computed using two different yardsticks. For instance, one interest payment may be computed using a fixed rate of interest, while the other may be based on a variable benchmark such as the T-bill rate.

Flowchart depicts the transaction.


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