Ch 14: Options

Question 1

Spot Contract vs. Future Contract

Answer 1

A spot contract is an agreement made between a buyer and a seller to complete a transaction today, e.g., buying foreign currencies at a bank.

A Futures contract is an agreement made today at a futures exchange between a buyer and a seller who are obligated to complete a transaction at a date in the future.

Question 2

If The buyer and the seller of a futures contract do not know each other, how is it completed?

Answer 2

The “negotiation” of futures price, the price at which a trade will occur, is determined through trading on a futures exchange.

Question 3

Futures Contracts include these things:

Answer 3

• the identity and quality of the underlying commodity or financial instrument,
• the contract size,
  the maturity or the expiration date,
• the delivery or settlement procedure,
  the futures price.

Question 4

Why is default risk eliminated?

Answer 4

because the futures exchange guarantees the performance of a futures contract. To cancel the contract, an offsetting trade is made in the futures market.

Question 5

Where are Canadian Futures Traded?

Answer 5

financial futures are traded at the Montreal Exchange. Commodity futures are traded at the Winnipeg Commodity Exchange.

Question 6

A futures contract represents a zero-sum game means that…

Answer 6

Gains realized by the buyer are offset by losses realized by the seller, and vice-versa.

Question 7

How are futures used for Hedging?

Answer 7

• Hedgers, such as farmers and mining firms, use the futures contracts to shift the price risk to speculators.
• Speculators take the price risk for profit potential.
• Hedging and speculation are complementary activities that exist for products (or assets) with price uncertainty.

Question 8

If you buy a future contract today, you are establishing a long position. This means that:

Answer 8

The objective of a long position is to profit from price increase:

• Every day before expiration, a new futures price is set in the trading process.
• If this new price is higher than the previous day’s price, the value of the futures contract will increase and the holder of a long position gains from this futures price increase.
• If this new price is lower than the previous day’s price, the value of the futures contract will decrease and the holder of a long position loses from this futures price decrease.

Question 9

Selling a future contract today is called

Answer 9

“Going Short” or establishing a short position.

The objective of a short position is to profit from price decline.

If this new price is higher than the previous day’s price, the value of the futures contract will increase and the holder of a short position loses from this futures price increase.

If this new price is lower than the previous day’s price, the value of the futures contract will decrease and the holder of a short position gains from this futures price decrease.

Question 10

Define Short Hedge:

Answer 10

Short hedge is to sell futures contracts while holding a long position in the underlying commodity or financial instruments. Short hedge protects the value of the inventory by offsetting the potential declines in the value of the inventory with the gains in the futures position.

Question 11

Define Long Hedge:

Answer 11

Long hedge is to buy futures contracts to “lock in” the price that a firm will pay for the commodity or financial instrument. Long hedge protects the purchaser by offsetting the potential price increase with the gains in futures position.

Question 12

Margin Requirements, name 2

Answer 12

1. Initial Margin: is the initial deposit when a futures position is first established. . Normally this is 2-5% of contract value.
2. Maintenance margin: is the minimum amount of cash that must be available in the account. Normally this is a fraction of initial margin.

Question 13

Margin Call

Answer 13

If the balance in the account drops below the maintenance margin, a margin call will be issued. A margin call is a request by the broker that more money be deposited into the account.

Question 14

How is a futures position closed out?

Answer 14

A futures position can be closed out at any time. This is done by entering a reverse trade. 95% of the futures contracts are closed out before expiration.

Question 15

What is a spot price?

Answer 15

price of a commodity or financial instrument is the price for immediate delivery. In reality, “immediate” delivery can be 2 or 3 business days later.

Question 16

basis = cash price – futures price

Answer 16

Cash prices and futures prices are seldom equal. The difference between the cash price and the futures price is known as basis.

Question 17

Carrying-charge market:

Answer 17

basis < 0, i.e., the cash price is less than the futures price. This usually happens for commodities with storage costs.

Question 18

Inverted market:

Answer 18

basis > 0, i.e., cash price is greater than the futures price. This sometimes happens when supply and demand change.

Question 19

In what forms are futures available?

Answer 19

Futures contracts are available as stocks, bonds, foreign currencies and stock indices

The underlying asset for the stock futures is 100 shares

Question 20

Spot-Futures Parity (IMPORTANT)

Answer 20

The relationship between spot prices and futures prices that must hold to prevent arbitrage opportunities is known as the spot-futures parity

Question 21

The spot-futures parity formula for a financial futures contracts is

Answer 21

F(T) = S* (1 + r)^T F is the current futures price, S is the spot price, r is the risk-free rate per period, and T is the number of periods before the futures contract expires

Question 22

What happens to The spot-futures parity formula if there is a Dividend paid near the end of the contract?

If there is a dividend yield?

Answer 22

F(T) = S* (1 + r)^T -D

F(T) = S* (1 + r - d)^T

Question 23

Index arbitrage

Answer 23

refers to trading stock index futures and underlying stocks to exploit deviations from spot- futures parity.

Question 24

What are the differences between buying stock index futures and buying stocks?

Answer 24

• Leverage: the leverage is high in futures market because of low margin requirement
• Costs of buying/selling stocks: it is difficult to buy/sell a basket of stocks because of brokerage commissions and the price effect of buying/selling many shares. It is easy to buy/sell index futures.
• Dividend payments: holding stocks receive dividends. Holding stock index futures do not receive dividends.

Question 25

Cross-hedging refers to

Answer 25

hedging a particular spot position with futures contracts on a related, but not identical commodity or financial instrument