Ch 10 - Forwards and futures

Question 1

What are derivatives?

Answer 1

Financial instruments whose valued is derived from another asset. Can be classified as financial and commodity derivatives

Question 2

What are the 3 main purposes of derivatives?

Answer 2

Hedging (risk reduction)
Speculation
Arbitrage

Question 3

What are forward contracts?

Answer 3

Over the counter contracts where 2 parties agree to buy or sell a specific amount of a specific asset at a pre-specified price and date

Question 4

What is meant by a long position in a derivative?

Answer 4

This party has the obligation to buy the underlying asset at maturity if the derivative is held until maturity

Question 5

What is meant by a short position in a derivative?

Answer 5

This party has the obligation to sell the underlying asset at maturity if the derivative is held until maturity

Question 6

What is forward price?

Answer 6

Price at which the transaction is carried out

Question 7

What is spot price?

Answer 7

Price of the commodity in the market

Question 8

What is meant by arbitrage in relation to derivative pricing?

Answer 8

Buying a security in one market and simultaneously selling it in another market at a higher price, thereby profiting from the temporary difference in prices. This is considered a risk free profit for the investor

Question 9

What are the 2 key principles in pricing derivatives?

Answer 9

1. It’s possible to construct a tracking portfolio consisting of the underlying asset and the risk free asset which tracks the payoff of the derivatives
2. if the payoff of the derivative and the tracking portfolio are the same, the cost of the construction must be the same to rule out arbitrage

Question 10

Forward price = __________

Answer 10

Spot price(1+r)^t

Question 11

The key to make arbitrage is selling ________ and buying ______ assets

Answer 11

Overpriced, underpriced

Question 12

What is shorting?

Answer 12

Borrowing a stock and selling it simultaneously in the market with a promise to lender to buy the stock at a later date

Question 13

What is a margin account?

Answer 13

Account that needs to be maintained by the long position in order to trade futures

Question 14

What is an initial margin?

Answer 14

The initial amount the long position must deposit to open the futures contract

Question 15

What is meant by marking to market?

Answer 15

When futures contract value fluctuates balance in the margin account is altered

Question 16

What is maintenance margin?

Answer 16

The threshold cash balance the investor must maintain in the margin account. If the account balance falls below this value then the investor top up the margin account to the initial margin

Question 17

Price of a commodity forward = ?

Answer 17

S(1+rf + cost of carry - convenience yield) ^t

Question 18

Cost of carry includes _______

Answer 18

Finance costs, storage costs, insurance

Question 19

What is convenience yield?

Answer 19

Benefit associated with holding the physical good rather than the associated derivative contrct