Derivatives: Options, Futures, and Forwards
What this domain tests
Payoffs, rights and obligations, and the hedging logic behind each contract. Options questions turn on intrinsic value versus time value and break-even arithmetic; futures and forwards questions turn on standardization, margining and counterparty risk.
Core rules
- Option buyer pays a premium and holds a right; writer receives the premium and carries an obligation. Maximum loss for a long call is the premium; maximum gain for a naked call writer is the premium.
- Intrinsic value: call = max(0, S − K); put = max(0, K − S). Time value = premium − intrinsic value.
- Break-even: long call = strike + premium; long put = strike − premium.
- Futures are exchange-traded, standardized, cleared through a clearing corporation, and marked to market daily with margin. Forwards are OTC, customized, and carry counterparty credit risk.
- Hedging: a portfolio manager expecting a decline buys puts or sells index futures; an exporter receiving foreign currency sells a currency forward.
Worked example
An investor buys one call with a $50 strike for a $3 premium. At expiry the stock is $58.
- Intrinsic value at expiry = 58 − 50 = $8
- Profit = 8 − 3 = $5 per share, or $500 on a 100-share contract
- Break-even share price = 50 + 3 = $53 Below $50 the option expires worthless and the loss is the $3 premium. Between $50 and $53 intrinsic value exists but the position is still a net loss - the distinction between payoff and profit is where candidates lose marks.
Traps
- Reporting payoff when profit is requested (ignoring the premium).
- Assuming a forward requires daily margin - it does not; futures do.
- Confusing American exercise (any time before expiry) with European exercise (expiry only).
- Forgetting that futures are a zero-sum contract between buyer and seller, with the clearing corporation as counterparty to both.
Key points
- Long call maximum loss is the premium; the writer's maximum gain is the premium.