Question

Futures contracts and options contracts can be used to modify risk. Identify the fundamental distinction between a futures contract and an option contract, and briefly explain the difference in the manner that futures and options modify portfolio risk.

Short answer

Futures contracts are obligatory in nature while options contracts are rights.

Modifies portfolio’s risk in different ways.

Step-by-step solution

Definition of options contract

Option contracts provide options means the right to option holders to exercise their right in terms of buy or sell of securities at a pre-decided date.

Difference between Futures and options contract

Following are important differences:

a. While futures contract is an obligation to accept or deliver the security or commodity at a specified date, the buyer of an options contract has the right to accept or deliver anytime during the life of contract.

b. Futures and options contract modify a portfolio’s risk in different ways. While in case of futures contract, it affects a portfolio’s upside and downside risk by a similar magnitude, in case of options contract, it doesn’t do so. Its impact on the risk profile of a portfolio is asymmetrical.