BULE HORA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

COURSE TITLE:- FINANCIAL MARKETS AND INSTITUTIONS

ANSWER TO INDIVIDUAL ASSIGNMENT I

Instructor:- Dilgasa Bedada(PhD Scholar)

Submittrd by;-Zegeye Tirunah (2nd Year)

Id. No.WP00303/14

January11,2023
Assignment (Individual)
(I). Answer the following questions
1. Forward/a futures/ an option contracts and their payoff diagrams
Forward contracts
A forward contract is an agreement between two parties – a buyer and a seller to
purchase or sell something at a later date at a price agreed upon today.
Forward contracts are for delivery of the underlying asset for a certain delivery
price on a specific time in the future. It involves a specific seller delivering an
asset to a specific buyer at a fixed price on a specific future date. The specified
future date is called the expiration date (at time T) and the specified price is called

Future contracts
A futures contract is an agreement between a buyer and a seller where the seller
agrees to deliver a specified quantity and grade of a particular asset at a
predetermined time in futures at an agreed upon price through a designated
market under stringent financial safeguards.
A futures contract, in other words, is an agreement to buy or sell a particular
asset between the two parties in a specified future period at an agreed price
through specified exchange.
For example, the S&P CNX NIFTY futures are traded on National stock
exchange.
A financial futures contract is a standardized agreement to deliver or receive a
specified amount of a specified financial instrument at a specified price and date.

• Gains and losses of future contracts are marked to market daily. Hence,
the account is adjusted at the end of each trading day based on the
settlement price to reflect the investors gain or loss.
Popular Futures Contracts :-

- Interest Rate Futures Many of the popular financial futures contracts are
on debt securities such as Treasury bills, Treasury notes, Treasury bonds,
and Eurodollar CDs. These contracts are referred to as interest rate futures.
For each type of contract, the settlement dates at which delivery would
occur are in March, June, September, and December.
- Stock Index Futures There are also financial futures contracts on stock
indexes, which are referred to as stock index futures. A stock index futures
contract allows for the buying and selling of a stock index for a specified
price at a specified date.

Op t i o n s
An option is a contract giving its owner the right to buy or sell an asset at a fixed
price on or before a given date.
For example, an option on a building might give the buyer the right to buy the
building for $1 million on or anytime before the Saturday prior to the third
Wednesday in January 2010.
Options are a unique type of financial contract because they give the buyer the
right, but not the obligation, to do something. The buyer uses the option only if
it is advantageous to do so; otherwise the option can be thrown away.

• Two basic option types:

– Call options

– Put options
A call option
• It gives the owner the right to buy an asset at a fixed price during a
particular time period. There is no restriction on the kind of asset, but the
most common ones traded on exchanges are options on stocks and bonds.
A put option
• It can be viewed as the opposite of a call option. Just as a call gives the
holder the right to buy the stock at a fixed price, a put gives the holder the
right to sell the stock for a fixed exercise price.
Option Payoff diagram
Figure3-Call Option Payoff diagram Figure4-Put Option Payoff diagram
2. Underlying asset

• An underlying asset can be used to identify the item within the agreement
that provides value to the contract.
• The underlying asset supports the security involved in the agreement, which
the parties involved agree to exchange as part of the derivative contract
Examples of Underlying assets are:-Financial instruments such as Bonds,
Stocks, Mortgage securities and other derivatives.
3. Long and Short Positions

In the trading of assets, an investor can take two types of positions: long and
short. An investor can either buy an asset (going long) or sell it (going short).

While long and short in financial matters can refer to several things, in this
context, rather than a reference to length, long positions and short positions are
a reference to what an investor owns and stocks an investor needs to own.

A. Long Positions

In a long (buy) position, the investor is hoping for the price to rise. An investor
in a long position will profit from a rise in price. The typical stock purchase is a
long stock asset purchase.

A long call position is one where an investor purchases a call option. Thus, a long
call also benefits from a rise in the underlying asset’s price.

A long put position involves the purchase of a put option. The logic behind the
“long” aspect of the put follows the same logic of the long call. A put option rises
in value when the underlying asset drops in value. A long put rises in value with
a drop in the underlying asset.
 B. Short Positions

A short position is the exact opposite of a long position. The investor hopes for,
and benefits from, a drop in the price of the security. Executing or entering a
short position is a bit more complicated than purchasing the asset.

In the case of a short stock position, the investor hopes to profit from a drop in
the stock price. This is done by borrowing X number of shares of the company
from a stockbroker and then selling the stock at the current market price.

4. Exchange traded/Over-the-Counter Market

Secondary market refers to a market wherein already issued securities and
financial instruments are traded. It includes both exchanges and OTC market
I. Exchange traded Market :-
Refers to the formally established stock exchange wherein securities are traded
and they have a defined set of rules for the participants.
When the trading is performed through the exchange, it is under the supervision
of the exchange and so it ensures that all the rules and regulations are duly
complied with.
II. Over the Counter (OTC)
- is a dealer oriented market of securities, which is a decentralized and
unorganized market where trading happens by way of phone, emails, etc
Some specialized futures contracts are sold “over the counter” rather than on an
exchange, whereby a financial intermediary (such as a commercial bank or an
investment bank) finds a counterparty or serves as the counterparty.
These over-the-counter arrangements are more personalized and can be tailored
to the specific preferences of the parties involved. Such tailoring is not possible
for the more standardized futures contracts sold on the exchanges.
5. Types of traders

• Speculators
They are traders using the included financial contracts to profit based on the
difference between the strike price (predetermined price) and the spot price
(current market price). Speculators use various tools and techniques to
understand the market and try to predict the future price of the underlying
assets.
If they think that the underlying asset's price may go up in the next few months,
they buy a financial contract of that asset and sell it before the expiry date when
the spot price is higher to make a profit. Speculators can trade in various
contracts irrespective of the underlying asset, ranging from equities to
commodities. As they want to avoid the delivery of the asset but to make a profit,
they usually sell the contract before the expiry date.
● Arbitrageurs
They are traders who take advantage of the geographical differences between the
prices of the same underlying securities in two markets. When such entities enter
the market, they ensure they can get a better price for the same underlying assets.
Once identified, arbitrageurs buy those securities attached to the financial
contracts in one market, only to sell them at a higher price in a different market.
Such entities make profits through market imperfections that remain
unidentified to others.
● Margin Traders
These traders use a part of their investment amount to buy and sell financial
contracts but utilise margins from the stockbrokers. They purchase and sell
contracts daily and profits based on the price movement of the underlying assets
within a single day.
When such margin traders identify profitable financial contracts, they take a
margin as credit from the stockbrokers. Once they sell, they return the margin
amount to the brokers with interest.
6. Payoffs and Profits
The payoff at expiration is the dollar amount the investor receives at expiration
from following the option strategy.
The profit at expiration is the payoff, minus the cost of the setting up the strategy.
Figure 5. Profit diagram of different Option contracts

Figure6. Profit diagram for Long and Short future

Figure7 Profit diagram of Forward Contracts
(II). multiple choice Answers
1.B
2.A
3.A
4.D
5.D
6.A
7.B
8.B
9.C
10.C
11.D
12.C
13.D
14.A
15.C
16.D
17.A
18.C
19:B
20.B