Discuss the cost-benefit trade-offs between options and forwards, and in what market situations each would be used.
The following features work differntly in Forwards & Options differentiatiing the trade offs.
1. Margins : Forward contracts dont require a margin or initial payment. A buyer or seller of an Options contarcts has to pay initial margins.
2. Customised - Forwards are customised between buyer and seller, like customised quantity (3/4 of a truck load instead of 1 truck load)
3. Right or the choice to exercise - One can default by not adhering to a forwards contract (meaning not following the initially agreed terms). One can exercise 'right' in an options contract.
4. Maximum Loss : Limited maximum loss in case of option buyers . A forward contract buyer may also incur losses, but in a losing situation, he may chicken out of the contract. The losses here are more of intangible nature - Loss of reputation, by not honouring a commitment etc.
5. Known buyer and seller - When the buyer and seller known each other and have a continuing relationship, a forward contract is better
6. In volatile markets and price uncertainity, it is better to use options instead of Forwards
7. Options are traded on an exchange platform, thus are more liquid. If one is looking to liquidity aspect as well, options are better.
8. Exiting a contract maybe difficult in forward, but options, because they are traded on exchange, have an easy exit option.
9. Dates - Delivery dates are flexible in forward contracts
10/. Quality of physical commodity in case of forwards is subject to Individuals discretion. Options are exchange traded and therefore have standards already in olace.
11. Default risk - Higher in forwards, lesser in Options.
Discuss the cost-benefit trade-offs between options and forwards, and in what market situations each would be...
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