1 - Intro to futures and forwards Flashcards
What is uncertainty?
Lack of complete certainty
Existence of more than one possibility
The “True” outcome is not known
what is measurement of uncertainty?
A set of probabilities assigned to a set of possibilities
What is risk?
State of uncertainty where some of the possibilities involve a loss, injury, catastrophe or other undesirable outcome
What is measurement of risk?
A set of possibilities each with quantified probabilities and quantified losses
Define low inflation
Small shock may cause deflation
Less manoeuvre for policy changes
Define deflation
When people expect that prices will be lower in the future, they spend less today.
Deflation discourages new borrowing
Wages and prices are generally sticky : causes unemployment
what are the two issues that constitute risk?
- That results do not meet expectations (in terms of quantum)
- That results do not meet expectations (in terms of timing)
What is a derivative?
An instrument whose value depends on, or is derived from, the value of another asset
Give an example of derivatives
Futures, forwards, swaps, options, exotics
What is the underlying variable or instrument known as?
The underlying
What do underlying assets include?
Stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance pay-outs, the weather
What is the role of derivatives?
They play a key role in transferring risks in the economy
Many financial transactions have embedded derivatives
The real options approach to assessing capital investment decisions has become widely accepted
How are derivatives traded?
On exchanges e.g. Chicago Board Options Exchange
On the over-the-counter market
What are the three trading approaches to risk?
- Hedgers
- Speculators
- Arbitrageurs
What are hedgers?
Aim to protect themselves against the adverse effects of risk
What are speculators?
Will use risk and instruments to manage it in order to make a profit
What are arbitrageurs?
Will use differences in “risk perception” in different markets to buy/sell securities in those markets to “lock in” a riskless profit
What is a forward contract?
forward contract is an agreement to buy or sell an asset at a specific price on a certain future date. It’s different from a spot contract, which is for buying or selling assets today.
A forward contract is traded on the over-the counter market
In a forward contract, one party agrees to buy the asset at the future date and price (long position), while the other party agrees to sell it on the same date and price (short position).
What is the forward price?
The forward price for a contract is the delivery price that would be applicable to the contract if were negotiable today
What is the acronym for SPOT?
Settlement price on trade
What is the spot price?
Is the price for immediate or almost immediate delivery
One counterparty assumes the Long Position One counterparty assumes the Short Position
Which is the buyer and which is the seller?
Buyer
Seller
Example of a forward contract
merchant and farm er
The merchant agrees to buy an amount of wheat from the farmer at a given
price.
* The merchant takes a LONG forwards position at the forwards price.
The farmer agrees to sell an amount of wheat to the merchant at a given
price.
* The farmer takes a SHORT forwards position at the forwards price
If the spot price is higher than the futures price. Who benefits the merchant or the farmer?
The merchant benefits and the farmer loses out by this amount
What is a futures contract?
Agreement to buy or sell an asset for a certain price at a certain time
Is traded on an exchange
The underlying:
- The commodities: pork bellies, live cattle, sugar, wool, lumber,
copper, aluminium, gold, etc.
- The financial assets: stock indices, currencies and Treasury
bonds,
If the spot price is lower than the futures price. Who loses out the merchant or the farmer?
The merchant loses out and the farmer benefits
What are future exchanges?
Futures exchanges make sure that contracts are completed, so they take on the risk that investors might not follow through on their side of the deal. This is called default risk
How is credit risk managed of a future contract?
To manage the credit risk of a futures contract, exchanges use a process called margining.
At the end of each trading day, they update each investor’s margin account to show their daily gains or losses based on the settlement prices. This is called:
Daily Settlement, or
Marking to Market
What do circuit breakers do?
They are employed to avoid large speculative movements on the exchange
What are price limits?
The max. daily price movement allowed (↑/↓).
Trading closes for the day if a Limit Move occurs.
Prevents large speculative price movements
What are position limits?
The max. number of contracts an investor may hold.
This prevents any one investor unduly influencing the market.
What does a futures contract include?
»The Asset
The subject of the trade.
If there are different grades of quality (e.g. corn or orange)
juice, the specific quality grade.
» Contract Size
The amount of Asset to be delivered.
» Delivery arrangements
The place where delivery must occur
(often specified by the Exchanges).
» Deliver months
The month in which delivery will occur.
What is the opening price?
The first price at which the contract is traded at the beginning
of a trading session.
What is the closing price?
The last price at which the contract is traded at the end of a
trading session
What is the settlement price?
A representative price, chosen by the Exchange, from the
closing range (prices in the last 30/60 seconds of trading).
This is a contract’s official closing price
What are the four market orders for future contracts?
Market order
Limit order
Stop-Loss
Market if
What is a market order
A trade be carried out at the most favourable price available
in the market
What is a limit order?
Specifies that an order may be executed at particular or more
favourable price
What is a stop-loss?
This becomes a market order once a specified Order price is
reached. It is used as a means of limiting losses should markets
move unfavourably
What is a market if?
This becomes a market order once a specified Touched price is
reached. It is used as a means of capturing gains on a contract
should markets move favourably
What three ways can future contracts be settled?
physical delivery
cash settlement
exchange-for-physicals
