Using a numeric example, illustrate and explain the pay-offs of a futures option and a futures contract.

Advanced Financial Management Block Revision Mock Exams

a) Future options give the holder the right to buy (call) or sell (put) standardized future contracts for a specified period of time at a specified strike price.
A future contract is an agreement for a specified performance at a time in the future.

Assume that 1000 tonnes of maize is available at Shs.10,000 per future contract of 1 tonne. Call option is at Sh.500 per tonne. If the future prices (when performance is to be fulfilled) are Shs.14,000, Shs.10,000 and Shs.6,000 per tonne, the pay offs are (for the holder of the future options) and “supplier” in future contracts.

As the table of pay offs shows, in the case of the future option, the holder limits the loss that he can incur to the option premium. In the future contracts, the potential loss is bigger with a maximum if the prices drop to zero.

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