Lesson 7 of 7 · All lessons in this module
- Forward contracts and firm commitments
- Futures contracts and daily settlementVideo lesson
- Swaps as a series of forwardsVideo lesson
- Options and call payoffsVideo lesson
- Put payoffs and the four option positionsVideo lesson
- Credit default swapsVideo lesson
- Forward commitments versus contingent claimsVideo lesson
Lesson 7 of 7 · 12 min
Forward commitments versus contingent claims
Forwards and options can give similar exposure to an underlying, but a forward's payoff is linear and costs nothing up front, while an option trades a premium for a payoff that is cut off on one side.
In short
- Firm commitments oblige both parties and have linear, symmetric payoffs; contingent claims let the buyer choose and have non-linear payoffs.
- With , a long call is like a long forward with downside protection bought for . The two profits are equal at ; above that the forward is better.
- A short put also gains when the price rises, but gives up the upside in exchange for . Profits are equal at ; above that the forward is better.
- Rising price helps: long forward, long call, short put. Falling price helps: short forward, long put, short call.
- Firm commitments: no premium, two-way credit risk. Options: premium paid up front, credit risk only for the buyer.
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