Forwards are quite common in commodities, and can be used either for speculation or for hedging.
Eg: If a person has an order to ship 10000 tons of steel for a period of 6 months at a prefixed price of $1000 per ton. And the person is expecting the price of steel to increase. So, to hedge against the price risk, the person enters into a forward purchase agreement, for 10000 tons 6 months hence. The person position is now fully hedged: if the price of steel increases as expected, person will either claim a delivery from the forward seller, or a net settlement. If the price comes down, person will be obliged to settle by making a payment for the price difference to the forward seller, but will be fully compensated by the pre-fixed price it gets from its own forward sale contract.
2. Options have an asymmetric return profile: an option is an option with one party. The option will be exercised only when the purchaser of the option is in-the-money. Therefore, the only loss in an option is the cost of writing and carrying the option. Hence, options have an asymmetric return profile. On the other hand, the option-seller only makes returns by way of fees or premium for selling the option, against which the person takes the risk of being out-of-money. If the option is not exercised, person makes fees, but if the option is exercised, considerably, the person may lose.
For example, if one person is holding a security of $1000 buys an option to put the security at its current price with some other person. Now if the price of the security goes down to $900. The person may exercise to sell the option of the security to some other person at the agreed price of $1000 to protect against the loss of account of turn down in the market value. If, on the other hand, the price of the security is increased to $1100, the person is out of the money and exercising the option of selling the security does not yield any gain at a price of $1000 as agreed. Therefore, the person will not exercise the option. In other words, the option buyer can only get paid and will not in a position of loss.
2. Compare the pay-off profiles of an open position and a forward contract with the pay-off profile of an option. Demonstrate that, on an ex post basis, a currency option is always second best.
A. The most popular derivatives instruments are forwards, future and option. The Forward contract obligate the buyer to purchase an asset at the pre agreed price where as seller can sell the asset at the exercising price. This is not standardized one. These represent the trade over the counter. The buyer and seller discuss about the contract, which yields to flexibility. This flexibility leads to liquidity of price. If any party wants to get out of agreement, they must find another party, who is willing to purchase that contract. In forward contract during the contract and at the time of forming the contract, no payments will be prepared; the value of contract is realized only at