Options markets, Financial Management

Options Markets:

Man has always been innovative and ingenuous. His determination to improvise and overcome the limitations of various processes has resulted in phenomenal and epoch-making discoveries and inventions. To overcome the limitations of proprietorship firms, he discovered the limited companies concept. To limit his dependence on term lending institutions he invented various types of instruments to raise long-term as well as short-term finance like different types of debentures, commercial paper and global depository receipts.

Options and Futures are also the result of this unrelenting search for better financial instruments. They belong to a class of instruments referred to as ‘Derivatives' because they derive their value from an underlying commodity or a financial asset. The underlying commodities and financial assets can range from mundane products like wheat and cotton to precious items like gold, silver, petroleum, and financial assets like stocks, bonds and currencies. Options on commodities have existed in different forms since 1860 for products as diverse as gold, wheat and tulip bulbs in the USA. An active over-the-counter market in stock options has also existed there for nearly a century. However, large-scale manipulations by intermediaries and the absence of standardized contracts resulted in the investors incurring heavy losses due to which the commodity options disappeared from the listing of many exchanges by 1968. It was only in 1973 that organized exchanges began trading options on equities. In 1982, futures on equity and options on bonds made their appearance on stock exchanges.

Now, we shall look at some of the differences between options and futures.

  • In options, the obligation to honor the contract is on the writer of the option, whereas in futures both the parties are equally responsible to honor their obligations.
  • In options, the buyer has to pay the premium to the writer of the option. In futures, both the parties have to deposit the initial margin with the clearing house and then have to pay variation margin depending on whether the price fluctuation is favorable to them or not.
  • American options can be exercised any time before the expiration day, while the European options should be exercised on the last day of expiration period. In futures, no such distinction exists and the parties are expected to honor the contract on the settlement date.
  • In options, the buyer limits the downside risk to the extent of premium paid. He, however, retains the upside potential. In futures, the buyer is exposed to the whole of the downside risk and has the potential for all the upside return.
  • The expiration period for options is nine months, while for futures it is twelve months.
  • Options are employed by both hedgers and speculators, while trading in futures is by and large done by speculators.

 

Posted Date: 9/10/2012 9:23:35 AM | Location : United States







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