Main Theories Regarding the Importance of Forward Securities Market Functining

INTRODUCTION

Since their early history the Exchanges have aroused the public interest, holding the promise of wealth and success. Due to this interest, they have become the most dynamic markets worldwide, undergoing tremendous change in the last two decades.

Buyers enter the market for various money market instruments, bonds, mortgage debt, or equity with the understanding that a purchase will result in an immediate transaction. With the exception of a few days of settlement time to complete the transaction, necessitated by mail delays, international date lines, and administrative details, purchase of one of these assets results in ownership transfer at the time of trade. Launching the trading of specific instruments – futures and options contracts – the Exchanges have created markets which encountered a rapid and unprecedented expansion. Therefore, understanding and participating in these markets is an endeavour that requires both theoretical and practical knowledge.

The last decade has seen a growth in markets in which futures, forward and options are actively traded. These instruments have proved to be an important part of the financial menu for both hedging and risk-taking activity.

The first market is the futures market, wherein future financial claims are actively traded. Here, investors may purchase financial assets that represent claims to real assets, such as gasoline, pork bellies, or corn, as well as other financial assets, such as Treasury bills or bonds, which will be delivered at some future date. The purchase of a futures contract involves a firm commitment to purchase something else at some future delivery date. The details of this market are rather complicated, and the mechanisms of trade are exacting, but as shall be explained, the futures market has greatly expanded investor opportunities to assume or transfer risk.

The second of these markets is the options market, wherein investors purchase the right to buy or sell an asset sometime in the future at a prespecified price. The contract to buy is referred to as a call; the contract to sell is referred to as a put. In either case, the options market provides investors with the ability to transact for real or financial assets, but it does not require them to exercise that option. This ability also greatly enhanced investor opportunities, whether they are interested in speculation or in hedging the risk inherent in their underlying business activity. Options are powerful tools and add new ways to adjust the risk and reward of trading. They allow investors and hedgers to create new ways locked into simply buying or selling a financial instrument. Now they can capitalize on such factors as changes in volatility and the passing of time.

Investors can now fine-tune their position to exactly fit their market perspective. Why take a big risk of buying an instrument when you are merely looking for a small rally? Use a bull spread instead! Do you think the market is going to drop for the next month, than rally? Use a calendar spread!

There are now options on most of the commonly traded financial instruments, including stocks, Treasury bonds, stock indexes, and futures.

When two parties agree to exchange a real or financial asset on a prearranged date in the future for a prespecified price, the agreement is known as a forward contract. Forward contracts are private agreements between two parties and are not negotiable instruments. The terms of the contracts are highly customized to the specific needs of the parties to the contract. The forward market operates through informal communication networks, and major participants include large financial institutions.

This paper reviews forward, future and options contracts, their use by institutions, the factors that determine their value, the technicalities that frequently cause volatility in the marketplace—delivery dates and contract expiration times. It also focuses on the basic theoretical models used to price valuation: the Black-Scholes and the Binomial option pricing models, Monte Carlo and Gordon-Shapiro models.