1 - Intro to futures and forwards

Question 1

What is uncertainty?

Answer 1

Lack of complete certainty
Existence of more than one possibility
The “True” outcome is not known

Question 2

what is measurement of uncertainty?

Answer 2

A set of probabilities assigned to a set of possibilities

Question 3

What is risk?

Answer 3

State of uncertainty where some of the possibilities involve a loss, injury, catastrophe or other undesirable outcome

Question 4

What is measurement of risk?

Answer 4

A set of possibilities each with quantified probabilities and quantified losses

Question 5

Define low inflation

Answer 5

Small shock may cause deflation
Less manoeuvre for policy changes

Question 6

Define deflation

Answer 6

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

Question 7

what are the two issues that constitute risk?

Answer 7

1. That results do not meet expectations (in terms of quantum)
2. That results do not meet expectations (in terms of timing)

Question 8

What is a derivative?

Answer 8

An instrument whose value depends on, or is derived from, the value of another asset

Question 9

Give an example of derivatives

Answer 9

Futures, forwards, swaps, options, exotics

Question 10

What is the underlying variable or instrument known as?

Answer 10

The underlying

Question 11

What do underlying assets include?

Answer 11

Stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance pay-outs, the weather

Question 12

What is the role of derivatives?

Answer 12

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

Question 13

How are derivatives traded?

Answer 13

On exchanges e.g. Chicago Board Options Exchange
On the over-the-counter market

Question 14

What are the three trading approaches to risk?

Answer 14

1. Hedgers
2. Speculators
3. Arbitrageurs

Question 15

What are hedgers?

Answer 15

Aim to protect themselves against the adverse effects of risk

Question 16

What are speculators?

Answer 16

Will use risk and instruments to manage it in order to make a profit

Question 17

What are arbitrageurs?

Answer 17

Will use differences in “risk perception” in different markets to buy/sell securities in those markets to “lock in” a riskless profit

Question 18

What is a forward contract?

Answer 18

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).

Question 19

What is the forward price?

Answer 19

The forward price for a contract is the delivery price that would be applicable to the contract if were negotiable today

Question 19

What is the acronym for SPOT?

Answer 19

Settlement price on trade

Question 19

What is the spot price?

Answer 19

Is the price for immediate or almost immediate delivery

Question 19

One counterparty assumes the Long Position One counterparty assumes the Short Position
Which is the buyer and which is the seller?

Answer 19

Buyer
Seller

Question 20

Example of a forward contract
merchant and farm er

Answer 20

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

Question 21

If the spot price is higher than the futures price. Who benefits the merchant or the farmer?

Answer 21

The merchant benefits and the farmer loses out by this amount

Question 21

What is a futures contract?

Answer 21

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,

Question 22

If the spot price is lower than the futures price. Who loses out the merchant or the farmer?

Answer 22

The merchant loses out and the farmer benefits

Question 23

What are future exchanges?

Answer 23

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

Question 24

How is credit risk managed of a future contract?

Answer 24

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

Question 25

What do circuit breakers do?

Answer 25

They are employed to avoid large speculative movements on the exchange

Question 26

What are price limits?

Answer 26

The max. daily price movement allowed (↑/↓). Trading closes for the day if a Limit Move occurs. Prevents large speculative price movements

Question 27

What are position limits?

Answer 27

The max. number of contracts an investor may hold. This prevents any one investor unduly influencing the market.

Question 28

What does a futures contract include?

Answer 28

»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.

Question 29

What is the opening price?

Answer 29

The first price at which the contract is traded at the beginning of a trading session.

Question 30

What is the closing price?

Answer 30

The last price at which the contract is traded at the end of a trading session

Question 31

What is the settlement price?

Answer 31

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

Question 32

What are the four market orders for future contracts?

Answer 32

Market order Limit order Stop-Loss Market if

Question 33

What is a market order

Answer 33

A trade be carried out at the most favourable price available in the market

Question 34

What is a limit order?

Answer 34

Specifies that an order may be executed at particular or more favourable price

Question 35

What is a stop-loss?

Answer 35

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

Question 36

What is a market if?

Answer 36

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

Question 37

What three ways can future contracts be settled?

Answer 37

physical delivery cash settlement exchange-for-physicals