Question 2 10 marks Both futures and options enable investor

Question 2 (10 marks) Both futures and options enable investors to hedge the risk associated with the adverse price movement of the underlying assets. However, some investors prefer using options rather than futures. (10 marks) Discuss Two advantages of utilizing options over futures and One benefit of using futures over options in setting up investment strategy.

Solution

Options, as the name suggests, provides the option holder with the right but not the obligation to purchase/sell the underlying asset (on which the option is based) at a fixed price and at a fixed time in the future. Future and Forward contracts, on the other hand, are binding and need to be squared off using an actual physical delivery or by means of an equal opposite position in the futures/forwards. Another advantage of using options is the wide range of underlying assets on which the same is available. In comparison, futures and forwards are available on a much smaller universe of underlying assets.

Futures have a much deeper market in terms of liquidity owing to the humungous volumes of futures contract traded in exchanges all over the world. Hence, futures score over options in terms of market liquidity.