Fundamentals of Financial Instruments, 2nd Edition

CHAPTER 7Options Contracts

INTRODUCTION

Forward and futures contracts, which we examined earlier, are commitment contracts. That is, once an agreement is reached to transact at a future point in time, noncompliance by either party would be tantamount to default. In other words, having committed to the transaction, the long – whom we have defined as the party who has agreed to acquire the underlying asset – must buy the asset by paying the pre-fixed price to the short. At the same time, the short is obliged to deliver the underlying asset in return for the payment.

Now 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 holders and need not be exercised if it is not beneficial for them. An obligation, on the other hand, mandates them to take the required action, irrespective of whether they stand to benefit or not. Contracts to transact at a future point in time, which give buyers the right to transact, are referred to as options contracts, for they are being conferred an option to perform. When it comes to bestowing a right, there are two possibilities. Buyers can be given the right to acquire the underlying asset or they can be given the right to sell the underlying asset. Consequently, there are two categories of options: call options and put options. A call option gives the buyers of the option the right ...