Wednesday, January 26, 2011

price of futures^options; demystifying MV^PnL

If a 2022 futures contract is traded today at a price of $1k, it's not a present market-value, and it's not an amount to be transferred from the buyer to the seller TODAY. The $1k is the amount to be transferred in 2022 -- scheduled payment.

Unlike stocks and bonds, Futures prices are not pinned to current market-value, but are actually forward prices, or scheduled-payments. However, the scheduled payment affects cash flow immediately - end of today. Introducing margin mark-to-market rule of the clearing house! This rule converts[1] the scheduled payment due 2022 into a cash transfer EOD _today_ between the long and the short accounts.

[1] using no discount factor.

Q: So what's the current valuation of a long futures position?
%%A: wrong terminology
%%A: a security has a valuation. Based on the valuation, a position has an unrealized-PnL
%%A: PnL = current MV (ie mid-market price) - trade price.

Option current prices are pinned to current market value, which is not same as the payoff on expiry. If an option is traded at $1k, this price is computed from a formula using expected payoff.

Note A holder of a Call/Put option owns a never-negative valued security. A short seller of any option "owns" a security of always-negative value. If you understand that option is an insurance, then Insurance company can only pay (excluding the one-time premium) and the insured can only receive.

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