411 - exam 1 Flashcards

Question 1

Q

CH. 1 - Futures contracts

Answer

A

-agreement to buy/sell an asset at a certain time in the future for a certain price -traded on several exchanges (CME group, intercontinental exchange, Euronext…)
-have a long and short side - long agrees to buy and shrot agrees to sell
-futures price - determined by S & D (if more ppl want to sell than buy…price goes down…if more people want to buy than sell…price goes up)

Question 2

Q

history of futures mkts.

Answer

A

middle ages - for farmers anc merchants - uncertainty about price farmer will rec. for corn - exposed to many risks - comp. who needs corn as raw material also exposed to price risk - futures minimizes risks both sides face

originaly an OPEN OUTCRY SYSTEM - where traders physically met on floor of exchange to use hand signals to signal trades they wanted - now electronic trading on comp. to match buyers/sellers

Question 3

Q

CBOT and CME

Answer

A

CBOT - Chicago Board of Trade

-established 1848 - to bring farmers and merchants together to standardize quantities/quality of grain traded - first type of turures contracts developed
-ppl started trading the contract more than the grain itself
-developed future contracts on several diff. assets (corn, oats, wheat, t-bonds, notes)

CME - chicago mercantile exchange - 1874 - established to provide mkt. for butter, eggs, poultry and other perishable goods

-1919 became futures trading mkt. - now large futures mkt. for commodities
-1972 - started trading futures contracts on foreign currencies (eurodollar)

Question 4

Q

OTC trading and systemic risk

Answer

A

trading directly btwn 2 parties without supervision of exchange
–options and futures are popular exchange-traded contracts!!!!

systemic risk

-risk that default by one fin. institution will create a “ripple effect” that leads to defaults by others and threatens stability of fin. system
–in OTC mkt. possible if bank A fails, bank B will take huge loss, lead to bank B fail which hits bank C etc…
-during fin. crisis…some banks called “too big to fail” bc concerns about systemic risk if they failed

Question 5

Q

how OTC works and three imp. regulatory changes

Answer

A

a non fin. comp. who wants to trade a derivative in OTC mkts. contacts derivatives dealer (usually large bank) - reach agreement and dealer absorbs risks as part of portgolio - dealer sometimes becomes counterparty with another dealer

OTC is LARGER THAN EXCHANGE TRADED MKT

–grew rapidly before 2008 crisis
-value of all OTC contracts oustanding in Dec. 2014 is about $21 T

OTC MKTS. - banks, fin. insit., fund managers are main participants in OTC derivatives mkts. (Ave. size of transactions in OTC is bigger than exchange traded mkts….but # transactions are smaller)

Question 6

Q

Three imp. regulatory changes

Answer

A

OTC mkt. used to beunregulated until Lehman brothers crisis

three imp. changes
1. standardized OTC derivatives btwn 2 fin. instututions in US must when possible be traded on SWAP EXECUTION FACILITIES (SEFs) - platforms similar to exchanges where mkt. particpants contact each other to agree on trades

req. global called CENTRAL COUNTERPARTY (CCP) - used in standard derivatives transactions btwn 2 fin. instit. - CCP stand’s btwn 2 sies in same way exchange does in exchange traded derivatives mkt.
all trades must be reported to a central depository

Question 7

Q

Forward contracts

Answer

A

similar to futures in that it is an agreement to buy/sell an asset in certain time in future for certain price - but futures traded on EXCHANGES and fwd traded in OTC MKTS.

FWD contracts pop. on foreign exchange

spot traders - trade foreign currency for almost immediate delivery
fwd traders - trade for delivery at future time
- -quotes are for very large transactions

Question 8

Q

Types of traders - 1. hedgers

Ex. May 2015, US comp. knows it will have to pay 10M pounds in Aug. 2015 for good purchased from British supplier

Ex. US comp. exporting goods to Britain on May 13, 2015 - knows it will rec. 30M pounds three months later

Answer

A

many diff. types of traders in derivatives mkt. and easy to find counterparty bc high demand
–hedge funds have become big users of derivatives for all three purposes

hedgers - use futures, fwds, options to reduce risk they face from potential future movements in mkt. variables

Ex. May 2015, US comp. knows it will have to pay 10M pounds in Aug. 2015 for good purchased from British supplier
○ Hedges foreign exchange risk by buying pounds (GBP) from fin. Institution in 3 mo. Forward market at 1.5742 —> fixes price for British goods at $15,742,000

Ex. US comp. exporting goods to Britain on May 13, 2015 - knows it will rec. 30M pounds three months later
○ Hedge foreign exchange risk by selling 30M pounds in three month forward market at exchange rate of 1.5736 - locks USD to be realized for pounds at $47,208,000

Question 9

Q

hedging with fwd contracts

May 13, 2015 - must pay 10M pounds in Aug. for goods purchased from Britain

Answer

A

used for netrualizing risk by FIXING the price the hedger will pay or rec. for underlying asset

May 13, 2015 - must pay 10M pounds in Aug. for goods purchased from Britain - buys 10M in 3-mo. Fwd market to lock in exchange rate of 1.5742 for pounds it will rec.
○ If exchange rate is 1.5 in August and company is not hedged, the 10M pounds it has to pay will cost $15,000,000 - less than $15,742,000
○ But if exchange rate is 1.6, costs $16,000,000 - wish it had hedged

Question 10

Q

hedge funds and hedgin

Answer

A

have become major users of derivatives

-similar to mutual funds - invest funds in behald of clients - but accept funds only from prof. fund managers or sophistiated indiv. and no publicly offered securities
-free from regulations so freedom in inv. strategies

hedge funds use inv. strategy

evaluate risks fund is exposed to
decide which risks are acceptable and which to hedge
devise strategies (usually with derivatives) to hedge unacceptable risks

Question 11

Q

types of traders - 2. speculators

Ex. Feb., speculator thinks British pound will strengthen relative to USD over next to months and will back theory with 250,000 pounds - assume current exchange rate is 1.547 USD/ GBP and april futures price is 1.5410 USD/GBP

Answer

A

want to take a position in the mkt. - are betting price will go up or betting it will go down

using FUTURES ex.
—–Ex. Feb., speculator thinks British pound will strengthen relative to USD over next to months and will back theory with 250,000 pounds - assume current exchange rate is 1.547 USD/ GBP and april futures price is 1.5410 USD/GBP

Can buy 250,000 on spot market now, hoping they can later sell the pounds for higher price if it goes up in future
- —Would buy 250,000 pounds for 1.547 dollars per pound and sell for 1.6 dollars per pound
- —–So profit (1.6 - 1.547) * 250,000 = 13,250.0 (PROFIT)
- —-Or if the exchange rate falls to 1.5 USD/GBP
- —Loss is (1.547 - 1.5) * 250,000 = 11,750.0 (LOSS)
Can take long position in four CME April futures contracts - each for the purchase of 62,500 pounds
- —If exchange rate goes to 1.6 - means the speculator with futures contract realizes profit of (1.6 - 1.541) * 250,000 = 14,750.0 (GAIN)
- — If exchange rate falls to 1.5 USD/ GBP
- —Realizes a loss of (1.541 - 1.5) * 250,000 = 10,250.0 (LOSS)

Question 12

Q

types of traders - 3, arbitrageurs

Answer

A

locking in a riskless profits by entering into transactions in 2+ markets
–earn riskless profits by exploiting some mispricing
• Arbitrage opp. Do not last long - as arbitrageurs buy stock in NYC, S & D forces will cause Dollar price to rise - and as they sell stock in London, pound price will be driven down
○ 2 prices quickly reach equilibrium at current exchange rate
• Mostly assume no arbitrage opp. Exist

Question 13

Q

Class derivatives intro.

exchange traded (how much of each in total)
OTC (how much)

Answer

A

exchange traded

-futures = 38T
-options = 58T

OTC - ALL about - $594 mkt. value

total mkt. value of equity traded is about $69T –> so derivatives mkt is about 10x the equity market (bc of need…companies want to hedge risk)

Warren Buffet’s description - they are good bc allow us to manage risk or get rich fast - very usefull to companies that use them

Question 14

Q

ex. using futures to hedge risk

Ex. Boeing rec. an order for 11 787s to be delivered btwn 2020-2025 - price is #3.25B (deal with All Nippon Airways)
–what risks do they face and how can futures help them hedge?

Answer

A

Ex. Boeing rec. an order for 11 787s to be delivered btwn 2020-2025 - price is #3.25B (deal with All Nippon Airways)

What risk do they take on???

— Price of materials increasing
—Credit risk of All Nippon - macroeconomic factors in the foreign country
—Inflation - if they are being paid and the dollar is high…they are at risk of losing value of their deal pmt.
—Exchange rate risk (not as large bc contract at risk - but dealing with foreign company)
–Trade

How can derivatives help them

–Materials costs? - FUTURES contract on steel (contract now to buy steel at a predetermined price when they need it)
—Credit risk - require them to put money down now…or can have a CREDIT DEFAULT SWAP
– rate risk –> currency futures contract

Question 15

Q

setting prices of futures in hedging

Answer

A

ex. need to produce 100,000 bushels of wheat
- –exposed to risk that price of wheat will go up in jly, which hurts net profits of twinkie business
- -solution: buy wheat futures contracts on CME group

prices of futures are set by S&D liks stock prices - in ex. saw one contract has min. 5000 bushels for $5.31 per bushel - so if need 100,000 bushels need to uby 20 contracts

Question 16

Q

arbitrage 4 strategies

Current Feb. contract is $52.22 per barrel and May is $53.34
–how would they exploit arbitrage opp?

Answer

A

find the relative misprision
buy low, sell high
borrow or invest as needed
unwind positions at maturity

Current Feb. contract is $52.22 per barrel and May is $53.34

—–Buy in Feb. (long) and agree to sell May (short) at 53.34 per barrel
—-In Feb. they borrow $52.22 at 4% - then in May they sell for $53.34 - no risk bc never put in any of there own money
—-Owe about 1% in may bc kept it for 1/4 of year - so $52.22 * 1.01 = $52.74 that they pay back

So they have a profit of 53.34 - 52.74 = 0.6 cents per barrel
Arbitrage bc they made an agreement at a locked in buy (long) and sell (short) price to make a 60 cents per barrel profit (without using their own money or exposing themselves to any risk)
—–BUT also have storage costs to hold their barrels they bought for 3 months before selling –> storage costs could eat up the whole 60 cents profit

Question 17

Q

POD 2 - short fwd contract on 100M japanese yen (JPY)
–enter when fwd exchange rate is .0085 USD/JPY

How much does trader gain/lose on contract (in USD) if spot exchange rate at contract expiration is
A. .0078 USD/JPY
B. .0101 USD/JPY

Answer

A

He is shorting, so agreeing to sell Japanese yen (100M) at .0085 USD/ JPY
—so agreeing to sell for 850,000

A. exchange rate goes down to .0078 - so when he pays back the borrowed yen he buys them at cheaper price and GAINS
–bc dollar strengthened! takes fewer dollars to purchase 1 yen
= 70,000 (Sales p - purchase p) * quantity

B. price increases to .0101 USD/YEN

–so if he shorted…he now has to buy back at higher price)
–so loss of (.0085 - .0101) * 100M = -160,000

Question 18

Q

forward contracts vs. futures

Answer

A

FORWARD

-OTC trading - private contract btwn 2 parties
-have to hold to maturity (generally)
-one party assumes LONG and one assumes SHORT position
-customized (do not have to conform to standards of exchange)
-settled at END of contract (on delivery date) - date agreed to by both parties….where futures are delivered any date within delivery month)
-actually deliver/cash settlement
–some credit risk

FUTURES

-traded on exchange
-can close anytime - call broker to close out
-standardized contract
-daily settlement (margin account) - (so every day gains/losses determined)
-rarely delivery - closed out before maturity - but rang of delivery dates
-virtually no credit risk

FWD ex.

-In Jan. farmer contracts to sell IM lbs. of apples @ 20/lb.
-in Nov. = mkt price = 10/lb.
-sale completed
-farmer rec. $200,000
-happy he entered contract

FUTURES ex.

-farmer SHORTS futures contract for 1M pounds of apples (maybe 10 contracts)
-Nov. contract and price is $20/lb.
-in Nov. farmer closes out contract (closes short)
-means he starts with short and in Nov. takes the long position to exit mkt.
-then his net gain after selling at spot of $10/lb. is (.20 - .10) * 1M apples = $100,000 gain plus the 100,000 from selling in spot = 200,000 profit
-bc in short you gain on price drops!! and then he lost in real mkt.
-if price in nov. spot was $30/lb. - he would lose $100,000 in futures but sell each for 30,000 and make 300,000 - so net gain would still be 200,000
-futures are easier and cheaper to close out

ex. where stlering exchange rate for 90-day fwd is 1.6 $ per pound - rate also futures price
- -under fwd - whole gain/loss realized at end of life of contract
- -under futures - gain/loss realized day by day

Question 19

Q

which position should they take in futures to hedge risk?

If the investor will gain when the price decreases and lose when the price increases
If the investor will lose when the price decreases and gain when the price increases, a short futures position will hedge the risk

Answer

A

they need a long futures

2. they need a short futures

Question 20

Q

The CME Group offers a futures contract on long-term Treasury bonds. Characterize the investors likely to use this contract.

“Options and futures are zero-sum games

Answer

A

a) Hedge an exposure to long-term interest rates.
b) Speculate on the future direction of long-term interest rates.
c) Arbitrage between the spot and futures markets for Treasury bonds.

means that the gain (loss) to the party with the short position is equal to the loss (gain) to the party with the long position. In total, the gain to both parties is zero.

Question 21

Q

A United States company expects to have to pay 1 million Canadian dollars in six months. Explain how the exchange rate risk can be hedged using (a) a forward contract

A U.S. company knows it will have to pay 3 million euros in three months. The current exchange rate is 1.1500 dollars per euro. Discuss how forward and options contracts can be used by the company to hedge its exposure.

Answer

A

The company could enter into a long forward contract to buy 1 million Canadian dollars in six months. This would have the effect of locking in an exchange rate equal to the current forward exchange rate.

enter into a forward contract obligating it to buy 3 million euros in three months for a fixed price (the forward price). The forward price will be close to but not exactly the same as the current spot price of 1.1500.

Question 22

Q

Explain the arbitrage opportunity when the price of a dually listed
mining company stock is $50 on the New York Stock Exchange and $60 CAD on the Toronto
Stock Exchange. Assume that the exchange rate is such that 1 USD equals 1.18 CAD.

Answer

A

Arbitrage involves carrying out two or more different trades to lock in a profit. In this case, traders can buy shares on the NYSE and sell them on the TSX to lock in a USD profit of 60/1.18−50=$0.85 per share. As they do this the NYSE price will rise and the TSX price will fall so that the arbitrage opportunity disappears

Question 23

Q

opening and closing futures

Answer

A

futures contract referred to by its DELIVERY MONTH

-delivery time usually within whole month - party with SHORT position chooses when delivery is made
-usually no delivery in futures - close out before delivery bc inconvenient and expensive
-a hedger usually wants to buy/sell the asset underlying the futures contract but prefers their own buyers and uses futures purely to hedge

to close out a position - enter into an opposite trade to the original one that opened the position
—ex. trader buys 5 july corn future contracts on 5/6 and closes out position on 6/20 by shorting 5 july futures contracts

TOTAL GAIN/LOSS AT CLOSE OUT IS DETERMINED BY CHANGE IN FUTURES PRICE BTWN MAY/JUNE
—oh my bc they close out by either selling or buying the futures contract on the other side they were in…so they feel the impact of futures price changes when they close out

Question 24

Q

specification of futures contract

Answer

A

exchange must specify the exact nature of the agreement btwn 2 parties
–specify asset, contract size, where delivery will be made and when

RULE: short position chooses what will happen
–when short is ready to deliver, files a NOTICE OF INTENTION TO DELIVER with the exchange

Question 25

Q

specification futures - 1. the asset

Answer

A

the asset
- -if commodity - exchange checks grade/quality of it - price reflects
- -if fin. asset - well defined and unambiguous

Question 26

Q

specification - 2. contract size

delivery arrangments
delivery months

Answer

A

contract size
- -specified amt. has to be delivered under one contract
- -if size is TOO LARGE - many traders wanting to hedge small exposures or wanting speculative positions are unable to use exchange
- -if TOO SMALL - trading is expensive
- -also have “mini” contracts for smaller traders
delivery arrangements
- -delivery place - for commodities - if long position wants to change place, has to pay to short position who makes delivery
delivery months
- -precise period (whole month) when delivery can be made
- -chosen by EXCHANGE to meet needs of mkt. participants
- -exchange specifies when month’s contract trading begins and last day trading can take place for a given contract

Question 27

Q

specification - 5. price quotes, 6. price limits and position limits

Answer

A

price quotes
- -exchange defines - crude oil uses dollars/cents, treasury bonds/notes quoted in dollars and 32nds of a dollar
price limits and position limits
- -for most contracts, daily price movement limits specified by exchange
- -if one day price moves down from prev. days close by an amt. = to daily prie limit, contract called LIMIT DOWN or LIMIT UP if moves up by limit
- –LIMIT MOVE if moves either direction equal to daily price limit

trading usually stops for day once price changes reach limit - but limits can also be changed

position limits - max # contracts a speculator may hold - prevent from exercising influence on mkt.

Question 28

Q

conergence of futures and spot prices

Answer

A

as DELIVERY period for futures gets closer…futures price converges to spot price of underlying asset
–when delivery period is reached…the futures price = spot (or very close)

happens bc if futures price is above spot DURING delivery period, then there is arbitrage opp. bc

can sell (short) futures
buy asset
then make delivery and immediate profits

as traders cont. to exploit these arbitrage opp. the futures prices fall

if futures is below spot during delivery period…companies interested in aquiring asset find it attractive to buy futures then wait for deliver to be made…as they do this prices rise (of futures)

result is the 2 graphs!!!! on phone

Question 29

Q

margin accounts

Answer

A

if 2 investors get in touch with each other to trade directly on futures assets - obvious risks of default or one party backing out
–key role of exchanges is to ensure defaults are avoided in trading

DAILY SETTLEMENT

-ex. investor contacts broker to buy 2 Dec. gold futures contracts at $1,250/oz. with contract size of 100 oz. - so contracted to buy 200 oz. at price
-broker requires investor to deposit funds into a MARGIN ACCOUNT
—-INITIAL MARGIN - amt. deposited at time contract is entered ($6000 per contract in ex. = $12,000)
-at end of each trading day, margin acct. is adjusted to reflec investor’s gain/loss - called daily settlement, or mkt. to mkt.

ex. end of first day, futures price fell from $1,250 to $1,241
- -inv. lost (200oz. * -9) = $1,800 bc the gold contracted to buy at $1,250 can now be sold for only $1,241.
- -balance in margin account falls by 1800 to 10,200
- –if price of gold had risen to 1259 would inc. by 1800 and margin acount would instead have 13,800

Question 30

Q

cont. the daily settlement long example

Answer

A

daily settlement is not only arrangement btwn broker and client - when there is decrease in futuresprice so margin acct. of investor with long position decrease by 1800, money passed to broker of investor with short position
—also when there is inc. in futures price, brokers for parties with short positions pay money to exchange clearing house and brokers for parties with long positions rec. money from exchange clearining house

inv. can withdraw any balance in margin in excess of INITIAL MARGIN
- –MAINTENANCE MARGIN used to make sure margin acct. is never negative (usually 75% of initial margin)
- -if balance in margin acct. falls below maintenance margin - investor rec. a MARGIN CALL - and expected to put funds in to meet initial margin level again next day

extra funds deposited called VARIATION MARGIN - if not provided by investor after margin call, broker closes out position (in ex. woudl be ending contract by selling 200 oz of gold for delivery in Dec.)

most brokers pay interest on balance in margin account - so not true cost to investor - providing competitive int. rate imp. otherwise they could earn if put money elsewhere
–to satisfy initial margin req. investor can deposit liquid securities with broker (T bills, shares, cash)

where fwd is settled at end of its life, futures is settled daily - at end of each day, investor’s gain/loss is added/subtracted from margin account
–shows a futures contract is in effect closed out and rewritten at new price each day

Question 31

Q

exchange clearinghouse

Answer

A

set min. levels for initial and maintenance margin - but indiv. brokers may req. more margin

-margin levels determined by variability of price of underlying asset - higher if high variability
-margin req. also depends on trader - hedger that produces commodity futures contract is written on will have lower margin req. than speculator - bc less risk of default
-day trade - trader announces to broker intent to close out position in same day
-spread transactions - trader simultaneously buys contract on asset for a maturity month and sells contract on same asset for another maturity month

margin req. same for short as they are for long!!!

Question 32

Q

clearinghouse #2

Answer

A

clearing house - intermediary in futures transactions - guarantees performance of parties to each transaction - main role is to keep track of transactions and calc. net position of each member
—lots of members!! 0 brokers who are not members themselves have to channel business through a member and post margin with that member

slearing hosue member req. to provide clearing house initial margin clearing margin) which reflects total # of contracts cleared
–no maintenance margin for clearing member - transations settled at end of each day - if losses, member req. to provide variation margin to clearing house (beg. of next day) - if there is gain, member rec. variation margin from clearing house

margin req. for members determined by # contracts oustanding on net basis (short positions offset against long)
—ex. clearing house has 2 clients - one with long position in 20 contracts and other with 15 contracts - initial margin calc. on basis of 5 contracts

members req. to contribute a GUARANTEE FUND - used by clearing house if member defaults and its margin is insufficient to cover losses

helps avoid credit risk!!!

Question 33

Q

OTC markets and risk checking - central counterparts

Answer

A

—no exchange - so credit risk is common in OTC - borrowed ideas from exchange traded mkt. to reduce CR

CENTRAL COUNTERPARTIES
- -clearing house for standard OTC transactions - similar roles as exchange clearing houses
- -members provide initial margin and daily variation margin - also conitrbute to guaranty fund
- -once 2 parties agree - present contract to CCP who accepts and becomes counterparty for both A and B (both sides of futures trade) by agreeing to:
buy asset from B in one year for agreed price
sell asset to A in one year on agreed price

CCP takes on credit risk of both A and B
–req. to provide finial margin but transactions NOT valued daily - leads to variaiont in margin pmts.

Question 34

Q

bilateral clearing in OTC transactions

Answer

A

OTC transactions not cleared though CCPs cleared this way - where 2 companies (A/B) enter into master agreement covering their trades

–both groups provide collateral - which req. transactions to be valued each day
-ex. if one day value increases to A by “X” amt. , is a decrease in value to B by X amt. and B req. to provide X collateral to A
-X in above ex. would be similar to variation margin

initial margin in both bilateral clearing and CCP provides interest..but daily variation represents daily settlement and does not earn interest
—neither OTC transactions are settled daily

Question 35

Q

Market quotes

-open interest
-opening price
-settlent price

futures patterns
–normal mkt.
–inverted mkt.
(look at graphs!)

Answer

A

trading volume - # contracts traded in a day

open interest - # contracts outstanding (# of long positions and # of short positions)

–if there are lots of traders involved (enter/close out on same day) vol. of trading in a day can be greater than beg. of day or end of day open interest
–depends on what buyers/sellers are doing - if 200 long open and 200 short open same day - open int. is 400 (c not each other’s counterparties)

opening price - is highest price trading so far dring day and lowest price during day
—prices trading imediately after start of trading dat

settlement price - price used for calculating daily gainslosses of margin req.
–price at which contract traded immediately before end of day’s trading session

patterns of futures prices

normal mkt. - futures mkt. prices inc. with maturity (bc more risk further out)
inverted mkt. - futures mkt. prices dec. with maturity

Question 36

Q

delivery info.

Answer

A

most futures close out early - but possibility ot eventual deliery determines futures prices

delivery time and place determined by SHORT position
–when decide, short party’s broker issues INTENTION TO.DELIVER to exchange clearing house - says how many contracts wil be delivered, where and quality grade

if it is commodity - LONG party responsible for warehousing costs - fin. assets delivered by electronic transfer

price paid on delivery most recent settlement price - can be adjusted for grade, locatio of delivery

three critical days for contact

FIRST NOTICE Y - first day on which intention to make delivery can be submitted t exchange
LAST NOTICE DAY - last day they can submit intention to make delivery
LAST TRADING DAY - few days before last notice day

sometimes impossibel to deliver - ex. if have futures of S&P 500 - can’t deliver protfolio of 500 stocks…so settle with cash = spot price of underlying asset

Question 37

Q

2 main types of traders executing trades:

then speculators are sub-divided in 3 titles

Answer

A

FUTURES COMMISSION MERCHANGS (FCMs) - follow instructions of clients and charge commission
LOCALS - trading on their own account

speculators sub-divided into 3 titles

SCALPERS - watch for very ST trends and attempt to profit from small changes in contract price
DAY TRADERS - hold position for less than one trading day
POSITION TRADERS - hold position for long time hoping to make profits from major mkt. movements

Question 38

Q

5 diff. types of orders!!!!!!

Answer

A

MARKET ORDER
- –simplest type - request that trade is carried out immediately at best price available in market
LIMIT ORDER
- -specifies a specific price
- -order only executed at his price or one even more favorable to investor - could never execute if price is neer seen
- –ex. if want to buy at limit price of $30, only willing to buy at $30 or less
STOP ORDER/STOP-LOSS ORDER
- -also specifies a price
- -order is executed at best available price once a bid/offer is made at that particular price or a less-favorable price
- -ex. stop order to sell at $30 issued when mkt. price is $35 - becomes order to sell when price falls to $30
- -stop order becomes mkt. order as soon as specified price is hit
- -point to closeout position with unfavorable price movements to limit loss
STOP-LIMIT ORDER
- -combo of stop and limit
- -becomes order as soon asbid/offer is made at price = to or less favorable than stop price
- -have to specify both stop and limit price
- -ex. at time mkt. price is 35 - stop-limit order to buy is issued with stop price of 40 and limit price of 41
- -as soon as there is bid/offer at 40, stop-limit order becomes limit order of 41 - if stop and limit price are sae, order called stop-and limit order
MARKE-IF TOUCHED order (MIT)
- -executed at best available price after trade occurs at specified price or price more favorable than specified price
- -becomes mkt. order once specified price is hit - also called BOARD ORDER
- -ex. investor with long position in futures contract issuing isntructions to close out contract
- –stop order plays limit on loss that can occur if unfavorable price movements occur
- -but MIT order designed to ensure profits are taken if favorable price movements occur
- -opposite of STOP - once it reaches the price they are willing to buy/sell…turns to mkt. and is executed

Question 39

Q

regulations - CFTC and NFA

Answer

A

futures mkt. is regulated by CFTC (COMMODITY FUTURES TRADING COMMISION) since 1974
–Dodd-Frank Act 2010 changed derivatives in OTC to be cleared by CCPs

NFA (NATIONAL FUTURES ASSOCIATION) 1982 - organization of indiv. who participate in futures mkt. - prevent fraud and ensure mkt. operates in public’s best interest

Question 40

Q

accounting for futures

ex. comp. buys 5000 bushels of Mar 2017 corn in Sep for 250 cents per bushel - coses out in Feb for 380 cents per bushel
- -price of Mar 2017 coren on 12/31 is 370cents per bushel

not hedged company
hedged company

Answer

A

req. changes in mkt. value of futures contracts to be recognized when they occur UNLESS CONTRACT QUALIFIES AS A HEDge
- -If not hedged - gains/losses recognized in same period in which gains/losses occured - called hedge accounting

ex. comp. buys 5000 bushels of Mar 2017 corn in Sep for 350 cents per bushel - closes out in Feb for 380 cents per bushel
- -price of Mar 2017 corn on 12/31 is 370cents per bushel

     1. if NOT a hedge - -Acc. profit in 2016 = 5000 * .2 = $1000  - -the .2 was the change by the year end of 20 cents gain - -- the acc. profit in 2017 when close out in Feb. would be the inc. from 370 in Dec. to 380 in Feb. so 5000 * .1 = 500 reported then

  2. if contract is hedging purchase of corn - --Acc. profit in 2016 = 0 - -acc. profit in 2017 = 5000 * .3 = 1500

in ex. comp. is heding purchase of 5000 bushels of corn in Feb. 2017 - contract qualifies for hedge acc. and entire gain of 1500 is realized in 2017 (option 2)
—bc comp. hedged bushels - futures in effect ensures price paid is close to 350 cents per bushel

Question 41

Q

futures and taxes

Answer

A

2 key issues are nature of taxable gain/loss nad timing of recognition of gain/losses - either reconized as capital gains/losses or ordinary income

corp. taxpayer - cap gains are taxed at same rate as ordinary income - restricts ability to deduct losses

non corp. taxpayer - ST cap gains are taxed same as ordinary income - but LT cap gains taxed at lower rate than ordinary income

LT cap gains = gains from sale of capital asset held for 1+ yr.
–ST cap gains - sale of cap. gains less than 1 yr.

FOR FUTURES

–non corp. taxpayer - positions in futures treated as if they are closed out on last day of tax year
–gives rise to cap/gains losses
–60/40 RULE - treated as 60% LT and 40% ST w/o regarding holding period

hedging transactions are expempt from rule

enter hedging to reduce risk of price changes of currency fluctuations with respect to property held/to be held by taxpayer for purposes of producing ordinary income
to reduce risk of price/int. rate/currency changes with respect to borrowings made by taxpayer
- –gains/losses from hedging treated as ordinary income

Question 42

Q

Short hedges

Answer

A

hedges that involve a short position in futures contracts - appropriate when hedger already owns asset and expects to sell it at some point in future

–ex. farmer who owns hogs and knows they will be ready to sell in 2 months
–can also be used whe asset is not owned but will be owned in future
–ex. US exporter knows he/she will rec. euros in 3 months - will realize gain if euro. inc. relative to US dollar but loss ifeuro dec. - so futures woudl offset that

after gains/losses on both futures and reg. mkt. taken into acct….the effective price rec. will be close to agreed futures price

Question 43

Q

long hedges

Answer

A

involve taking long position in futures contract - appropriate when comp. knows it will have to purchase asset in future and wants to lock in price now

Ex. Copper fabricator knows it will need 100,000 pounds of copper on May 15 - futures price for May deliver is 320 cents per pound
—-Hedges position with long futures and closes out on May 15 - each contract for delivery of 25,000 pounds of copper - effect of locking in price of req. quantity at close to 320 cents per pound
—If on May 15, price is 325 cents per pound - May is delivery month so close out contract and gain…. 100,000 * (3.25 - 3.20) = 5,000
And pays 100,000 * 3.25 = 325,000 for the copper - net cost is 320,000 or 320 cents per pound

assume delivery NOT made bc costl and inconvenient - cose out before delivery period to avoid delivery

Question 44

Q

arguments for/against hedging

Answer

A

most people who hedge have no expertise in predicting variables: int. rates, exchange rates, prices —> hedge risks bc uncertainty

cons

-shareholders do hedging themselves in own portfolio
–so comp. hedging might not benefit shareholders bc their comp. might be a hedge itself
-if acting in best int. of shareholders, sometimes better not to hedge bc each portfolio is diff. and for some risk is good and for some is bad - easier for shareholders to indiv. diversify risk than the company

also if hedging is NOT norm in industry, may not benefit comp. to hedge if everyone else isn’t

-the competitive pressures within industry will push prices of goods/services to be mroe volatile
-comp. that does not hedge will expect profit margin to be constant, but hedged comp. would expect profit margin to fluctuate!!!

ex. gold jewelry industry
- –one comp. hedges and others do not
- –if price of gold goes up - econ. pressures will lead to inc. in wholesale price of jewlery so industry’s profit margin is unafected
- —-but hedged company’s profit margin will inc. bc of heding - bc locked in at lower gold price and reap benefits of high jewelry prices
- –but if price of gold dec….econ. pressures push price ofjewlery to go down - hedged comp. loses profit margin bc locked in at higher gold price than competitors (whose profit margins stay same)

Ex. of southwest and airlines on oil

Question 45

Q

hedging imp. to remember

Answer

A

while it can protect against losses in price movements (which they are always grateful for hedging in those cases)
–it can also lead to worse outcome than had they not - bc can’t reap full benefits of favorable price changes

also if don’t hedge might have regrets depending on mkt. changes

Question 46

Q

basis risk

Answer

A

basis risk = uncertainty in the basis when futures contract is closed out (that it wont be 0)

hedging not always straightfwd bc

asset whose price needs hedging may not be exactly same as asset underlying futures contract
hedger may not be certain of exact date asset will be bought/sold
hedge may req. future contract to be closed out befre delivery month

remember graph of spot and futures - bc of arbitrage opp….during delivery month the spot and future converge to be same price!!!

basis = spot - futures price

–if hedged asset and futures underlying asset are SAME - basis should be ZERO at expiration of futures contract
–INC. bassis = strenghtening the basis
-DEC. basis = weakining the basis

effective price paid with hedging is FUTURES PRICE + BASIS

Question 47

Q

cross hedging

Answer

A

when underlyingaset is diff. than asset that needs to be hedged

LEADS TO AN INC. IN BASIS RISK

Question 48

Q

two key factors that affect basis risk

Answer

A

choice of asset unerlyinh futures contract
- -have to be closely correlated!!!
choice of delivery month
- –usually choose contract with later deliver month - bc futures prices very volatile during delivery month - and long hedger wil risk change of taking delivery of physical asset
- -BEST TO CHOOSE DELIVERY MONTH THAT IS CLOSE TO, BUT LATER THAN, EXPIRATION OF HEDGE (For hedge expirations in Mar., April, and May –> the June contract will be chosen)

Question 49

Q

hedge ratio

Answer

A

ratio of size of position taken in futures contracts to size of exposure

–if asset being hedged and underlying asset in fuures are same, hedge ratio = 1.0
—ex. Hedger’s exposure to 20,000 barrels of oil and took long position in futures contracts for delivery of exactly same amount of oil

but in cross hedging 1.0 not always optimal - wants to choose value for HEDGE RATIO THAT MINIMIZES VARIANCE OF VALUE OF HEDGED POSITION

Question 50

Q

problems faced in basis risk

Answer

A

TIMING MISMATCH
- -have to close out prior to expiration
- –so basis is not 0 - risk that it is positive or negative
- -to avoid delivery and price volatility - USE CONTRACT CLOSEST TO, BUT AFTER, WHEN WE WANT HEDGE TO END (contracts are every 3 mo.)
asset mismatch
- –only so many future contracts out there - may not be one for asset you ened to hedge - find closest alternative
- –fubd most related contract in appropriate ratio - called cross hedging and req. regression analysis

Question 51

Q

basis strenghten/weaken good or bad for who

Answer

A

if basis strengthens = + from time
weakens = basis decreases over time

effective price is contracted price + basis

–so long party likes when basis weakens bc pays less
–short party wants basis to strengthen bc rec. more

Question 52

Q

asset mismatch regression analysis

Answer

A

need the MOST RELATED contract in the APPROPRIATE RATIO (amt. oc contracts we need) - calc. by regression analysis

find how some variable Y (dependent variable) is related to another variable x (Explanatory variable)
–regression finds line of best fit

slope of line is BETA (rise/run)
r^2 = % of variation in Y that is explained by variation in X = correlation
- -high R^2 wouldhave residuals close to line and low R^2 would spread residuals about line

in cross-hedging

–R^2 tells us - which contract is most related to asset being hedged
–Beta lets us know the appropriate ratio

when x = % change in future sprice of contract over time equal to life of contract
—y = % change in spot price of asset hedged

if beta inc. = measure of volatility of our portoflio over time relative to mkt - if beta inc. we need more contracts to hedge

Question 53

Q

basis pricing explained

Answer

A

S1 = 2.50, F1 = 2.20, S2 = 2.00, F2 = 1.90
B1 = .30, B2 = 2.00 - 1.90 = .10
basis weakened!!!

needs to sell asset –> so worried about price decreases…so short futures bc gain there if price decreases

so at time 2 - realize the $2.00 spot price bc sell at that time
–then gains in futures mkt is F1-F2 = (2.2-1.9) = .30

so the effective profit is the spot + gains in futures = S2 + F1 - F2 —> which is F1 + B2
–contracted price plus basis at expiration

the risk is in uncertainty of what B2 will be at time T2

Question 54

Q

hedging an equity portfolio

Answer

A

if portfolio MIRRORS index, optimal hedge ratio (h*) is 1.0 and contracts that should be shortedis just Va / Vf
—will explicitly say if it MIRRORS

if does NOT mirror

–use beta from regression as h*
-Beta = 2 - return on portfolio (Y) will be twice as big as return in index
–also twice as sensitive to mkt. changes so need TWICE as many contracts to hedge

LOOK OVER NOTES HERE AGAIN - THERE WAS AN EXAMPLE THAT IS IMP.

Question 55

Q

stock index

Answer

A

tracks changes in value of hypothetical portfolio of stocks = weight of stock changes at particular time
–if stocks remain fixed…weights assigned to indiv. stocks to not remain fix bc when price of one rises higher than others = more weight to that stock

Dow jones - 30 stocks - price weighted

S&P - 500 diff. stocks - weiht as proportional to their mkt. cap

NASDAQ - based on 100 stocks

futures contracts on stock indices settled in cash!!! - bc can’t deliver the underlying asset
—mkt to mkt either at opening price of closing price of index on last day

Question 56

Q

under what circumstances would min. variance hedge portfolio lead to no hedging at all?

Does a perfect hedge always succeed in locking in the current spot price of an asset for a future transaction?

Answer

A

when coefficient of correlation btwn changes in future prices and changes in spot prices is 0

No. Consider, for example, the use of a forward contract to hedge a known cash inflow in a foreign currency. The forward contract locks in the forward exchange rate, which is in general different from the spot exchange rate.

Question 57

Q

types of int. rates

Answer

A

int. rates are always amt. of money borrower promises to pay lender - rate depends on credit risk (BPs, 1 = .01%, 10 = .1%)

treasury rates
—rates inv. earns on T-billsbonds - gov. borrowed so low chance default = rf

Question 58

Q

LIBOR

Answer

A

London Interbank Offered rate

-unsecured ST borrowing rate btwn banks
-quotes on several diff. currenciies and borrowing periods (1 day - 1 yr.)
-LIBOR popl on many derivative transactions
–published daily by British bankers association at 11:30am UK time
-quotes usually bt AA rated banks - usually estimate of unsecured borrowing rate

Question 59

Q

overnight rates

Answer

A

banks req. to maintain certain amt. of cash (Reserve) in central bank - depends on oustanding A and L

–bc of reserve req. some don’t have enough at end of day and others have surplus = lending/borrowing oernight
-overnight rate is FED FUNDS RATE - weighted ave. of rates is effective fed fund rates

Question 60

Q

swap rates

Answer

A

most common agreement where LIBOR int. rate is exchanged for fixed rate of int. for period of time

–ex. 2 parties agree to exchange LIBOR (with rate reset every 2 mo.) applied to principal of $100M for fixed rate of int. at 3% per annum. applied to same principal for 5 years
-onc party pay LIBOR and rec. fixed rate of 3% and other would rec. LIBOR and pay fixed ratet of 3%

Question 61

Q

OIS rate

Answer

A

overnight indexed swaps

–swap where fixed rate for a period of 1-3 months is exchanged for geometric average of overnigh rates during period
–fixed rate in OIS called OIS rate
–if fixed rate is greater than gemetric ave. of daily rates for period – there is pmt .from fixed-rate payer to floating rate payer at end of period
-if fixed rate lower than geometric ave. - there is pmt. from floating to fixed rate

ex. in US 3 mo. OIS, the notional principal is $100M and fixed rate (OIS rate) is 3$ per annum. geometric ave. of overnight effecive fed funds rates during 3 months is 2.8% per annum
- –so fixed rate payer has to pay .25 * (.03 - .028) * 100M = $50,000 to floating rate payer

Question 62

Q

rf rate

Answer

A

central role in derivatives pricing - bc approach of valuing derivatives is setting up a riskless portfolio and arguing portfolio should return rf rate

–but derivatives traders do not use rates on T-bills/bonds as rf rates BC there are tax and regulatory factors that lead to treasury rates being really low
–before 2007 crisis, LIBOR rates were assumed rf rates…bc seemed unlikely bank woudl default on loan lasting less than 12 months
–but since crisis - started using OIS RATES as rf bc OIS is cont. refreshed one-day rate - very unlikely credit-worthy bank will default in one day

three month LIBOR-OIS SPREAD watched carefully to measure stress in fin. mkts.

-amt. by which 2 mo. LIBOR > three mo. OIS rate measures diff. btwn credit risk in 2 mo. interbank loan and credit risk in series of one-day interbank loans
–normal spread is about 10BPs or .1%

Question 63

Q

compounding interest rates

Answer

A

in derivatives always have Cont. compounding!!!

if Re = int. rate with cont. compunding

if Rm = int. rate with compounding “m” times per annum

Question 64

Q

zero rates

Answer

A

N-year zero can. int .rate is rate earned on inv. that starts today and lasts n years - all int. and principal realized at end of n years - no intermediate pmts.

n year zero can int. rate comstimes called n year spot rate, n year zero rate, n year zero

ex. 5 year zero rate with cont. comp. is quoted at 5% per annum
- -means if $100 invested for 5 years grows to be 128.40

in zero bonds, price of bond itself determines zero rate - but in reg. bonds, some of return of bond is realized in form of cpn pmts. prior to end of year 5

Answer 65

A

somtimes bond trades use same discount rate for all CFs underlying bond (FV and CPNs) but MORE accurae to use appropriate zero rate for each CF

bond yield = single discount rate - when applied to all cash flows gives bond’s value = to its mkt. price

do each CF * e^-r*t
–negative bc finding PV of each

in ex. Y = 6.76% (look at ex. again)

Answer 66

A

COUPON RATE!!(not YTM) that causes bond price to = its par value

ex. CPN on 2 yr bond is “C” per annum. or C/2 every 6 mo.

use zero rates, value of bond is = to PV of $100 when:

Answer 67

A

look at notes!!!

OIS rates are comp. (Q, SA, A) and zero rates are CC

bootstrap method gives ZERO CURVE

–with time to maturity on x and int. rates (per annum) on Y
–assumpion zero curve is linear btwn points determined by bootstrap method

also assume zero curve is horizontal!!!

Answer 68

A

determining OIS zero rates (Rf rates used by traders to value derivatives)

overnight indexed swap - exchanging a fixed rate for a floating rate

floating rate calc = assuming someone invests at (very low risk) overnight - reinvesting proceeds next day

Answer 69

A

rate implied by current zero rates for periods of time in the future

FWD RATE AGREEMENTS
–comp. x agrees to LEND $ to comp. Y at LIBOR for period btwn T1 and T2

Rk = rate of int. agreed in FRA
Rf = fwd LIBOR int. rate for period btwn T1 and T2 calc. today
Rm = actual LIBOR int. rate for period btwn T1 and T2 calc. today
L = principal underlying contract

all Rs are measured with comp. freq. to length of period they apply to

normally would earn Rm for int. but bc entered FRA earned (Rk - Rm)

FRAs are settled at T1, not T2 —> payoff is discounted from T2 to T1

Answer 70

A

orig. Amt. L*(Rk - Rm)(T2 - T1) - lender who rec. interest

then comp. Y’s CF –> L* (Rm - Rk) * (T2 - T1)
–borrower who pays the int.

so in 1st - comp X. (lender) will rec. int. btwn T1 and T2 at fixed Rf rate and pays interest at LIBOR rate (Rm)

2nd - comp. Y will pay int. on principal btwn T1 and T2 at fixed rate Rk and rec. int. at Rm

ex. comp. ledner enters into FRA to ensure it will REC. fixed rate (RK) of 4% on principal of $100M for 3 mo. period starting in 3 years
- –if 3 mo. LIBOR = 4.5% for 3 mo. period

CF to lender is 100M * (.04 - .045) * .25 = $125,000

Answer 71

A

!!!!!!!!!!to value an FRA 0 know always worth 0 when Rk= Rf
—or when contracted rate is equal to the calculated forward rate for T1 - T2

ex. TC Corp. FRA - rec. LIBOR (rec. floating and pay fixed)
- -pay 4%SC
- -principal = $10M
- -6 mo. period starting 4/1/21

what is value of FRA to RC?

-on date 4/1/20 - where FWD 6-mo. LIBOR for one year agead is 3.5% (both the .035 an .04 in formula below were Semi ann. - be consistent)
-1.5 yr. zero rate is 3.7% CC

on 4/1/20 = 10M * (.035 - .04) = -50000

expected payoff = principal * int. rate diff. * %of yr.
= 10M * (.035 -.04) * .5 = -25,000

-lost $ on FRA but later will get lower rate on borrowing so makes up for it
-if positive FRA gains - good but means borrowing rate will be more expensive (bc you subtract what you pay - so means the Rm was higher)

then find PV of FRA = -25000e^-.0371.5 = -23,650

if cont. comp. use e otherwise you need to change it to match

Answer 72

A

OTC (off exchange) contract designed to fix the int. rate that will apply to either borrowing/lending a certain principal amt. during specified future period
–when first negotitated - specified int. rate usually = FWD RATE - the contract then has zero value

based on LIBOR - rate that is agreed to when contract first entered is fwd LIBOR rate at time

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411 - exam 1 Flashcards

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