Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives

CHAPTER 7

Options Contracts

The forward and futures contracts that we examined in Chapter 6 are commitment contracts. In other words, once an agreement is reached to transact at a future point in time, noncompliance on the part of either party is tantamount to default. Having committed himself to the transaction, the long, who we have defined as the party who has agreed to acquire the underlying asset, must buy the asset by paying the prefixed price to the short. At the same time, the short is obliged to deliver the underlying asset in return for the payment.

Let us turn our attention to contracts that give the buyer the right to transact in the underlying asset. The difference between a right and an obligation is that a right needs to be exercised if it is in the interest of the holder, and it need not be exercised if it is not beneficial for him. An obligation, on the other hand, mandates him to take the required action, irrespective of whether or not he stands to benefit. Contracts to transact at a future point in time, which give the buyer the right to transact, are referred to as options contracts, because he is being conferred with an option to perform. When it comes to bestowing a right, there are two possibilities. The buyer can be given the right to acquire the underlying asset or be given the right to sell the underlying asset. There are two categories of options: call options and put options. A call option gives the buyer of the option the right to buy the underlying ...