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Distinguish option contracts from forward contracts and futures contracts.

FRM® Part I · Financial Markets and Products · Introduction to Derivatives · FRM1.FM.4.c

The idea

A forward contract is a private agreement to buy or sell an asset at a fixed price on a future date. Both parties are obliged to transact, nothing is paid at the start, and it is settled only at maturity, which leaves credit risk. A futures contract carries the same obligation but is standardised, exchange-traded and marked to market daily, with margin and a clearing house limiting credit risk. An option is different because the buyer holds a right and not an obligation. A call is the right to buy and a put the right to sell at the strike price. The writer must perform if the holder exercises. The buyer pays a premium upfront. European options are exercised only at expiry and American options at any time up to expiry.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which contract gives its holder the right, but not the obligation, to buy or sell an asset at a fixed price?

  1. A forward contractWhy not: A forward obliges both parties to transact at the agreed price on the delivery date.
  2. A futures contractWhy not: A futures contract is also an obligation for both sides; it is a standardised, marked-to-market forward.
  3. An option - correct
  4. A swap agreementWhy not: A swap is an obligation to exchange cash flows over several dates, not a right.

Only an option separates right from obligation: the buyer chooses whether to exercise and the writer is obliged to perform if exercised. Forwards, futures and swaps bind both sides.

A harder one

An investor writes a put option on a stock with a strike price of 60 and receives a premium. Which description of the position is correct?

  1. The investor may choose whether to sell the stock at 60Why not: Gives the writer the holder's right; the writer has only obligations once the option is sold.
  2. The investor must buy the stock at 60 if the holder exercises - correct
  3. The investor must sell the stock at 60 if the holder exercisesWhy not: Describes a short call; a put holder sells, so the put writer is the one who buys.
  4. The investor has the right to buy the stock at 60 and has paid the premiumWhy not: Describes a long call; the put writer receives the premium and holds no rights.

A put holder has the right to sell at the strike, so the writer must buy at 60 if exercised, in return for the premium received. The writer's position is an obligation with capped gain.

The hardest tier

A bank buys an OTC call option from a dealer, paying the premium in full upfront, and separately enters an OTC forward with the same dealer. Neither trade is collateralised. Which statement about credit exposure is correct?

  1. On both trades only the bank is exposed, because it is the buyer in eachWhy not: A forward has no buyer-only exposure: whichever side is in the money bears the credit risk.
  2. On the call only the bank is exposed to the dealer, but on the forward either party can be exposed, depending on whose side has positive value - correct
  3. On both trades each party is exposed at all times regardless of market levelsWhy not: Exposure exists only for the party whose contract has positive value; the other party owes.
  4. On the call both parties are exposed, while on the forward only the long is exposedWhy not: Once the premium is paid, the call writer has no claim on the holder, and the short forward can also be in the money.

After the premium is paid, the call writer has nothing to receive, so only the holder faces credit risk. A forward starts at zero value and either party may become the one owed money.

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