Futures and Options

Futures and options are widely used in financial markets to minimize the risk of underlying asset price.

Example

Company procures raw material of Rs.100 for their manufacturing and price suddenly increase into Rs 130 within 3 months of time. This has several impacts for manufacturers to produce their goods and sell it in the Market. This price fluctuation will disrupts the business operations.

So to avoid these kind of circumstances company will initiate a future contract agreement with their sellers to supply goods at predetermined price at specified intervals of time irrespective of disruption in prices in the market.

Now lets look at the scenario- if company booked their future purchase order agreement with seller.

Price of commodity is Rs 100 and agreement period is 1 year
If price of commodity goes to Rs 130- Buyer don't have to incur the loss of increase in price hike in raw material- since seller ships goods at agreed price in the contract irrespective of market price.
If price falls below the the agreed price- say., Rs 80- In this scenario - seller gains a profit of Rs 20 per unit and buyer has to pay the agreement price.

So- benefits are there for both the parties irrespective of price swings in the market.

Typically this example fits for crude oil prices in the market.
Refineries agreed to purchase at specified dollars in the agreement period- so that manufacturing cost of finished product does not fluctuates and profit remains intact and beneficial to economy as well - like petrol, diesel, and gas prices can be sold at nominal prices

Options- it is a derivative instrument typically used in hedging risks.
Underlying products are stocks, bonds, commodities, currencies.

Two types of options- Put and Call
Call - right to buy an underlying asset at agreed price and not on the market price.
Buyer will be bullish and seller will be bearish

Put - right to sell an underlying asset at the agreed price and not on the market price
Seller will be bullish and buyer will be bearish

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