Problem 1. What is the difference between a long position in a call option and a long forward contract?

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EXPERT ANSWER

Following are the key differences between long position in call option and long forward contract:

Long position in Call option

  • A long call option gives the buyer or holder the right, but not the obligation, to buy an asset at a specific price on or before a specific date.
  • A long call option provides the right but not the obligation to buy a security.
  • A long call options are traded at the exchanges
  • A long call options can be purchased on various securities, such as stocks and bonds, as well as commodities.
  • Call options are standardized contract. Long call options have specific lot size and are usually traded in capital market.
  • Long call or future contracts have clearing houses that guarantee the transactions, which ultimately lowers the probability of default.
  • Call option are the futures contracts that are mark-to-market daily, which means that daily changes are settled day by day.
  • Long call options have no counter party risk.
  • Call options or future contracts are quite frequently employed by speculators, who bet on the direction in which an asset’s price will move.

Long Forward contract

  • Forward contracts are agreements between two parties to buy or sell an asset at a specific price on a specific date.
  • A forward contract is an obligation i.e. there is no choice. Long party has to buy the contract.
  • Forward contracts are traded in the over-the-counter (OTC) market.
  • Forward contracts are reserved for commodities, such as precious metals and oil.
  • Forwards are highly customizable, allowing for a customized date and price.
  • Because forward contracts are private agreements, they take place in the OTC market and there is always a chance that a party may default on its side of the agreement.
  • For forward contracts, settlement of the contract occurs at the end of the contract.
  • Long forward contract have greater counter party risk.
  • Forward contracts are mostly used by hedgers who want to eliminate the volatility of an asset’s price.