7.2 Forward commitments and contingent claim features and instruments

Question 1

forward commitments

Answer 1

an obligation to trade

can be exchange-traded contracts (e.g., futures) or over-the-counter (OTC) contracts (e.g., forwards and swaps

Question 2

contingent claims

Answer 2

provide the buyer with the right to trade

Question 3

A forward contract

Answer 3

an agreement to make a trade at a future date

One party agrees to pay the forward price for an underlying asset and the other party agrees to sell at that price on a specific date.

The buyer of a forward contract has long exposure to the price of the underlying and benefits from any appreciation.

The forward contract seller is said to be short the underlying and benefits from any depreciation in its price.

Question 4

A futures contract

Answer 4

similar to a forward contract in that there is an agreement to purchase an underlying asset for a specific price on a specified date

Question 5

Differences between forwards and futures include:

Answer 5

1. Futures contracts are standardized, while forward contracts are customized terms.
2. Futures contracts trade on a public exchange with a clearinghouse that guarantees the performance of all traders. Forward contracts trade OTC with no performance guarantees, so traders must do their own assessment of counterparty credit risk.
3. Futures contracts are marked to market, which allows traders to realize gains or losses at the end of each day. By contrast, gains and losses for forward contracts are not realized until expiration.
4. Futures contracts are highly liquid instruments because it is much easier to take offsetting positions when trading standardized contracts. By contrast, forward contracts are usually held to maturity.

Answer 6

an initial margin deposit (typically less than 10% of the futures price) from both parties upon initiation

This serves as a performance bond to provide some assurance of the parties’ ability to cover possible future losses.

Question 7

daily settlement

Answer 7

At the end of each trading day, the clearinghouse credits gains to one party’s margin account based on the change in the futures price

all contracts are marked to the end-of-day settlement price.

Question 8

A margin call is made if

Answer 8

if an account balance drops below the maintenance margin

After receiving a margin call, a party must deposit sufficient funds to bring the account balance back to the initial margin level.

Note that it is not sufficient to bring the balance back to the maintenance margin

Question 9

the variance margin

Answer 9

The amount required to bring an account back up to the initial margin level

Question 10

The number of outstanding contracts for a particular underlying and settlement day is known as

Answer 10

the open interest

Question 11

A swap

Answer 11

can be thought of as a series of forward contracts, meaning that cash flows are exchanged on more than one date.

swaps are privately negotiated OTC transactions and each party is exposed to the risk that the other party will default. If the swap is registered with a central counterparty, both parties may be required to meet margin provisions.

Swaps are widely used instruments, with interest rate swaps being particularly popular

Question 12

For contingent claims, the payoff occurs if

Answer 12

if a specific event happens.

Examples include options, credit derivatives, and asset-backed securities

Question 13

An option

Answer 13

gives its owner the right, but not the obligation, to buy or sell an underlying asset

As with other derivatives, an option’s key terms (e.g., the underlying asset, exercise price, maturity date) are specified in advance

Question 14

A call option

Answer 14

grants the right to buy the underlying asset

Question 15

a put option

Answer 15

grants the right to sell the underlying asset

Question 16

European-style options

Answer 16

can only be exercised at maturity

Question 17

American-style options

Answer 17

can be exercised any time after initiation

Question 18

The value of an option after initiation depends on the

Answer 18

on the price of the underlying asset relative to the option’s exercise price

Question 19

when are option buyers exposed to counterparty credit risk

Answer 19

if their options are in the money

Question 20

Credit default swap (CDS) contracts

Answer 20

the most common type of credit derivative

These instruments are insurance-like contingent claims based on an underlying issue or index, with the buyer getting protection against adverse credit events (e.g., bankruptcy, failure to pay, involuntary restructuring)

The credit protection buyer makes a series of cash payments in return for compensation from the credit protection seller if a defined loss event occurs.

Question 21

Which of the following risks is most likely greater for futures contracts than forward contracts?

A
Credit risk

B
Cash flow risk

C
Interest rate risk

Answer 21

B
Cash flow risk

With the mark-to-market feature of futures contracts, the investor must have daily cash on hand to pay for any adverse deviation, so there is cash flow risk.

Question 22

An initial margin deposit for a futures contract is most likely:

A
a performance bond.

B
a margin account’s minimum allowable balance.

C
required of the short party only if the daily settlement price falls below the price specified in the contract.

Answer 22

A
a performance bond.

The initial margin requirement is required of both parties to a futures contract upon initiation. It serves as a performance bond to provide some assurance of the parties’ ability to cover possible future losses.

Question 23

A swap contract is most accurately described as an:

A
over-the-counter contingent claim.

B
exchange-traded forward commitment.

C
over-the-counter forward commitment.

Answer 23

C
over-the-counter forward commitment.

It is over-the-counter and not exchange-traded because it is a private, customizable transaction and not a public, standardized good.

Question 24

Assuming there are no defaults, what best describes a difference between forward commitments and contingent claims?

A
Forward commitments are traded over the counter, while contingent claims are traded on exchanges.

B
The occurrence of a future payoff is uncertain for contingent claims and certain for forward commitments.

C
A party must own the underlying asset to enter a forward commitments, while this requirement does not exist for contingent claims.

Answer 24

B
The occurrence of a future payoff is uncertain for contingent claims and certain for forward commitments.

Forward commitments have transaction terms that are agreed upon at initiation, whereas contingent claims have payoffs that are uncertain until they actually occur.

Question 25

Which of the following is most likely an example of an exchange-traded forward commitment?

A
Call options

B
Futures contracts

C
Forward contracts

Answer 25

B
Futures contracts

futures contracts are exchange-traded forward commitments.