Week 3: Closing thoughts

This week, we covered an important category of financial instruments - derivatives - and briefly looked at two representative financial derivatives - futures and options. We also discussed forward contracts. Overall, all those financial instruments are examples of financial contracts that allow investors to trade a specified underlying asset in the future. The underlying asset of a forward contract is often a commodity and this normally involves actual delivery of goods on the delivery date. This is unlike futures contracts where the underlying asset can be anything, including commodities, bonds, equities, or a portfolio of financial instruments. We examined some of the other differences between futures contracts and forward contracts and how investors use them to adjust their investment strategies.

For example, very often investors do not hold a futures contract until its expiration date. They can close their futures contracts at any time by taking an opposite position to the initial one. This flexibility is guaranteed by the mechanism of mark to market or daily settlement, which is a key feature of the futures market. More specifically, the value of all futures contracts will be re-evaluated or adjusted at the end of each trading day, making it possible for investors to adjust their investment strategies at any time. This flexibility does not exist for a forward contract. An options contract provides the investors with yet more flexibility than a futures contract.

This is because an options contract gives the option holder the right, but no obligation to buy or to sell in the future. Financial options work just like an insurance policy, protecting you when you need it, but having no value if you do not need to use it. Because investors benefit from holding an options contract, the buyer of the option has to pay a price or options premium upfront. So the pricing of an options contract is very important for investors. It is directly related to how market players form their expectations about the future price movement of the underlying asset.

If there is a high uncertainty surrounding the underlying asset then the demand for the options contract will be high, which raises the option premium. This is exactly what we saw in the 2007 and ‘08 global financial crisis when options premiums shot up significantly immediately after the crisis broke. Market players were not certain about what was going to happen in the financial market so they demanded more insurance for their investments. Next week, we will be moving on to discuss how financial derivatives can be applied in risk management for both financial and non-financial firms. I hope you can join us. Thank you.